A Primer On Avoidance Transactions Under Insolvency And Bankruptcy Code

Corporate insolvency and bankruptcy are critical issues that impact the financial stability and operational viability of businesses. In India, the Insolvency and Bankruptcy Code, 2016 (“Code”) serves as a comprehensive framework to address insolvency and ensure timely resolution. During insolvency or liquidation proceedings, the primary goal is to maximize the recovery of assets of the Corporate Debtor and distribute them fairly among stakeholders, ensuring that creditors are paid in accordance with their priority and shareholders receive their share of any remaining assets.

Here comes the role of avoidance transactions, which is aimed to undo all the prior transactions that were undertaken to benefit any particular creditor/set of creditors that harm the interest of all other creditors. By avoiding such transactions, the Code endeavours to maximise the assets of the Corporate Debtor and hence accords more protection to the creditors. The Insolvency Code contains four types of avoidance transactions, which are preferential, undervalued, fraudulent and extortionate credit transactions, covered under Sections 43, 45, 66 and 50 of the Code, respectively. These transactions are also known as PUFE transactions. This article aims to offer an in-depth exploration of the mechanisms behind avoidance transactions as outlined in the Code and to examine how the courts have addressed various issues related to these transactions.

Preferential Transaction

Analysis of Provision

Section 43 of the Code talks about what are preferential transactions and the relevant time. As per Section 43 (1) of the Code, if the liquidator or resolution professional believes that the corporate debtor (the company in question) has given preferential treatment to certain people during a specific period, they can request the Adjudicating Authority to avoid these transactions. This means they can seek orders to undo such preferential transactions.

Section 43(2) lays down the criteria for deeming any transaction to be preferential. A corporate debtor is considered to have given a preference if:

1. There is a transfer of the debtor's property or interest to benefit a creditor, surety, or guarantor for a previous debt or liability, and
2. This transfer puts the creditor, surety, or guarantor in a more beneficial position than they would have been if the company's assets were distributed according to the insolvency rules in Section 53.

One of the primary exceptions to the above clause is enumerated under Section 43(3) of the Code, which is transfers made as part of the ordinary course of business of a corporate debtor or transferee. Courts in various cases have defined what is an “ordinary course of business” for the purpose of code, which author will discuss in subsequent paragraphs.

Section 43 (4) of the code enumerates the relevant time period to look back for preferential transactions, which is two years in case the transaction is with a related party and one year in other cases, calculated from the insolvency commencement date.

Section 44 of the Code lists various orders that Adjudicating Authority can pass upon application under Section 43 by a resolution professional or liquidator.

Ingredients of Preferential Transaction

Supreme Court in the landmark case of Jaypee Infratech Ltd. Interim Professional v Axis Bank Ltd^[1], also known as the Anuj Jain case, enumerated some of the essential ingredients of the preferential transaction under the Code.

In this case, the Corporate Debtor (JIL) mortgaged 858 acres of land as collateral for debts owed by its Holding Company (JAL). The Interim Resolution Professional (IRP) of JIL filed an application to avoid these mortgage transactions, claiming they were preferential, undervalued, and fraudulent under Sections 43, 45, 49, and 66 of the Insolvency and Bankruptcy Code (IBC). NCLAT ruled that it was not a preferential transaction since it was undertaken in the ordinary course of business.

However, the Supreme Court held these transactions to be preferential.

Supreme Court held that the following question must be considered to rule that the transaction falls under Section 43 of the Code:

1. Is the transfer for the benefit of a creditor, surety, or guarantor?
2. Is the transfer related to an antecedent financial debt, operational debt, or other liabilities owed by the corporate debtor?
3. Does the transfer place the creditor, surety, or guarantor in a more beneficial position than they would be if the assets were distributed according to Section 53?
4. If the transfer benefits a related party (excluding employees), was it made within two years before the insolvency commencement date? If the transfer benefits an unrelated party, was it made within one year before the insolvency commencement date?
5. Is the transfer excluded under subsection (3) of Section 43?

However, even if the above conditions are met, the Court ruled that preferential transactions are allowed if they: (i) occurred during the ordinary course of business of both the corporate debtor and the transferee, or (ii) resulted in the provision of new value to the corporate debtor.

Ordinary Course of Business

In the Anuj Jain case (supra), the Court explained the meaning of “ordinary course of business”.

Section 43(3)(a) states that a transaction is not considered preferential if it was carried out in the ordinary course of business or financial affairs of either the Corporate Debtor or the transferee. However, the Supreme Court^[2] emphasized that this should be interpreted as "Corporate Debtor and transferee," meaning both parties must engage in the transaction within their ordinary course of business or financial affairs for it to be exempt from being treated as preferential.

The terms "ordinary course of business" and "financial affairs" are not defined in the IBC. The Supreme Court referred to the High Court of Australia's definition in Downs Distributing Co Pty Ltd vs. Associated Blue Star Stores Pty Ltd (in liq)^[3], which describes "ordinary course of business" as transactions that are part of the regular flow of business, unremarkable, and arising from no special circumstances.

To determine if a transaction with a related party was in the "ordinary course of business," the Supreme Court considered the specific relationship between the Corporate Debtor and its related party. For example, it was noted that a Corporate Debtor (as a special purpose vehicle) mortgaging its assets to secure its parent company's borrowings is not in its ordinary course of business.

Similarly, NCLAT in the GVR Consulting Services Pvt. Ltd. v. Pooja Bahry^[4] case referred to the UNCITRAL Legislative Guide for the purpose of understanding the meaning of “ordinary course of business”. It referred to para 165 of the Guide, according to which the term "ordinary course of business" is used to identify what constitutes regular business activities. This allows businesses to make routine payments and enter into standard contracts without the risk of these transactions being voided in insolvency. Examples of such routine payments include rent, utilities (like electricity and telephone), and payments for trade supplies.

The tribunal upheld the Mischief rule applied by the Anuj Jain case, where the Court ruled that the word "or" in Section 43(3) should be read as "and," meaning that a preferential transaction must be part of the ordinary course of business for both the corporate debtor and the transferee.

Upholding the Anuj Jain case, the tribunal concluded that the Corporate Debtor, which was involved in manufacturing and electronics projects, did not engage in the ordinary course of business by taking financial assistance from related and unrelated parties. The tribunal stated that the terms "ordinary course of business" and "financial affairs" in Section 43(3) should be interpreted narrowly and not include all financial transactions by the Corporate Debtor. They specifically noted that money obtained from related and other parties by the Corporate Debtor does not qualify as part of the ordinary course of business or financial affairs.

Intention is irrelevant

One of the main issues that the court has dealt with is the relevancy of intention in determining the preferential transaction.

Supreme Court in the Anuj Jain case ruled that ruled that Sections 43(2) and 43(4) are deeming provisions. Hence, a legal fiction would come into play in such a scenario, meaning the transaction would be deemed to be hit by Section 43 of the Code even if it was not intended or even anticipated to be preferential.

A similar question came up in the case of GVR Consulting, where NCLAT was asked to determine if the transaction would be deemed to be preferential even if there was no intention on the part of the corporate debtor to give any preference. The tribunal reiterated the position taken by Anuj Jain case and held that since legal fiction comes into play once the ingredients of Section 43(2) r/w Section 43(4) are fulfilled, the question of intent becomes irrelevant, and the transaction would be deemed to be preferential.

In GVR Consulting case, question also came up if the transaction was undertaken due to pressure of lender, will it still be hit by Section 43(2) of the Code or not. The tribunal ruled that whether the transaction was involuntary or voluntary it is not relevant for the purpose of determining whether it is preferential or not.

Tribunal Can't Suo-Moto Classify a Transaction as 'Preferential'

In Sahara India v. Shir Nandkisho Vishnupant Deshpande and Anr^[5], the NCLAT dealt with the question of whether the adjudicating authority can classify any transaction as preferential on its own without Resolution Professional applying for the same.

In this case, the NCLT noted that converting the operational debt into financial debt through the loan agreement by Resolution Professional was aimed at placing Sahara India in a more favourable position. The NCLT, on its own accord, classified this transaction as a Preferential Transaction under Section 43(2)(a) of the Code.

On appeal, NCLAT ruled,

According to Section 43 of the Code, it is the responsibility of the Resolution Professional or Liquidator to determine if a Corporate Debtor has given preference in a transaction. They must then file an Avoidance Application to the Adjudicating Authority for the transaction to be avoided. In this specific case, the Resolution Professional did not form an opinion that the Corporate Debtor had given preference, nor did the they file an Avoidance Application regarding the transaction. Therefore, it was beyond the NCLT's jurisdiction to classify the transaction as preferential on its own.

The appellate tribunal held that the NCLT overstepped its authority by classifying the transaction as preferential without an application from the Resolution Professional, as it does not possess the power under Section 44 to do so suo-moto. The Tribunal noted that the NCLT incorrectly identified the appellant as a related party, which was not within the scope of the petition.

In conclusion, the tribunal doesn't have the power to classify any transaction as preferential on its own, since the responsibility is on Resolution Professional to do that and apply to the adjudicating authority for its avoidance.

Undervalued Transaction

Section 45 of the Code deals with the Undervalued Transaction. As per this section, a transaction is considered undervalued if the corporate debtor (a) makes a gift to someone or (b) transfers assets to someone for a price significantly less than what those assets are worth.^[6]

Further, this transaction shouldn't have been undertaken under the ordinary course of business of the corporate debtor.

The relevant lookback period under Section 46 of the Code for undervalued transactions is two years in the case of a related party and one year in the case of a non-related party.

Moreover, as per Section 47 of the Code, an application for avoidance application under Section 45 can be moved to the adjudicating authority by the creditor, member or partner of a corporate debtor if the Resolution Professional fails to do the same.

The undervalued transaction was discussed by the court in the landmark case of IDBI Bank Limited v. Jaypee Infratech Limited^[7]. The tribunal here ruled that the corporate debtor mortgaged immovable property (unencumbered land) without receiving any consideration in return. The court deemed this mortgage an undervalued transaction under Section 45 of the Code since it was made without any consideration to the lender.

NCLT Mumbai, in the case of Ambit Finvest Pvt. Ltd. Vs. Rakesh Niranjan Ranjan & Ors.^[8], ruled that the Financial Creditor cannot file an avoidance application for PUFE except for undervalued transactions. This is because, for undervalued transactions, an application can be filed by a creditor, member or partner of a Corporate Debtor.

Moreover, NCLT Kolkata in Ply Com (P) Ltd. v. Nippon Alloy Ltd.^[9], ruled that the mere defence that the assets had high depreciation value and that the same could not be sold at a better price is not sufficient for the defence of an undervalued transaction unless it is backed by strong evidence. Mere ledgers and vouchers provide no proof to establish this contention.

Fraudulent Transaction

Section 66 of the Code deals with the Fraudulent Transaction. As per Section 66(1), “any person” is liable who has been knowingly a party to the transaction, which was undertaken with the intent to defraud creditors or for any fraudulent purpose.

As per Section 66(2), a director, or partner of the corporate debtor can be directed by the adjudicating authority to contribute to the assets of the corporate debtor if (i) they were aware or expected to be aware that there was no reasonable chance of avoiding insolvency and (ii) they failed to exercise due diligence to minimise potential losses to the creditors.^[10]

A director or partner is considered to have exercised due diligence if they acted with the level of care expected from someone in their position.

It is important to note that the NCLAT, in the case of Mr. Thomas George v. K. Easwara Pillai and Others^[11], ruled that there is no look-back period for fraudulent transactions, and a three-year limitation period under the limitation act will not apply. Hence, the Resolution Professional can look back to any time preceding the insolvency commencement date for the purpose of determining the fraudulent transactions.

'Fraud' under Section 66

NCLAT, in the case of Shri Baiju Trading and Investment Private Limited v. Mr. Arihant Nenawati^[12], discussed what is 'fraud' for the purpose of Section 66 of the Code.

Here, the Corporate Debtor was engaged in bullion trading and faced insolvency proceedings due to defaulting on payment of INR 4.9 Crores to Raksha Bullion. The appellant owed INR 41.03 Crores to the Corporate Debtor, which was written off by the debtor's directors before the CIRP started.

The Resolution Professional alleged this write-off as a fraudulent transaction under Section 66 of the IBC, seeking contributions to the debtor's assets from the appellant and the directors. NCLT found the transactions to be fraudulent and ordered contributions from the appellant and directors. It was appealed to NCLAT.

NCLAT observes that the 'fraud' for the purpose of Section 66 of the Code would consist of debts that the debtor has no intention or ability to repay or it could also happen upon false representation of repayment intent. Additionally, usage of the phrase “any person” would include all the knowing parties who took part in the fraudulent transaction.

The tribunal noted the unusual nature of the loan given by the Corporate Debtor, a company not in the lending business, and the lack of explanation or security for the write-off.

The tribunal held that the transactions like these, which lack any security interest or bank guarantee as collateral for the Corporate Debtor and are subsequently written off, can only be considered fraudulent acts intended to deceive the creditors of the Corporate Debtor. Clearly, the Appellant was the main beneficiary of this scheme.

The tribunal referred to the Ram Preeti Yadav Case, reinforcing the principle that beneficiaries of fraudulent transactions are presumed to be involved in the fraud.

Effect of Moratorium on Section 66

In Rakesh Kumar Jain v. Jagdish Singh Nain and Others^[13], the NCLAT ruled that the proceedings under Section 66 of the Code can be initiated against the Resolution Professional of a company undergoing CIRP and it is not barred by the moratorium imposed under Section 14 of the Code.

Here, the issue was whether, during the moratorium imposed under Section 14 of the Code, the Adjudicating Authority could pass an order under Section 66 of the Code or not.

The tribunal clarified that the bar imposed by Section 14 of the Code doesn't prohibit passing an order against the Resolution Professional and its suspended directors and related parties. Further, Section 66 empowers the Adjudicating Authority to pass an order against them.

The tribunal further noted that Section 14(1)(a) and Section 66 of the Code serve different purposes. Section 14 of the Code aims to prevent third parties from claiming amounts from the corporate debtor through execution of orders, decrees, etc., whereas Section 66 of the IBC is designed to prevent fraudulent trading or business practices by the corporate debtor. Therefore, the tribunal observed that Sections 14(1)(a) and 66 of the IBC should be interpreted in a way that harmonizes their purposes to effectively implement the Code.

Difference Between Section 49 and Section 66 of the Code

Section 49 is titled “Transactions defrauding creditors”. It refers to the situation where a corporate debtor enters into an undervalued transaction, and such transaction was deliberately entered to keep assets of the corporate debtor beyond the reach of any person who is entitled to make a claim against the Corporate Debtor or in order to adversely affect the interests of such person.

Section 66 refers to the situation where during the insolvency process it is found that any business of the corporate debtor has been carried on with intent to defraud creditors of the corporate debtor or for any fraudulent purpose. It also covers the situation where director or partner of the corporate debtor has acted negligently and didn't exercise due diligence in minimising the potential loss.

The similarity between Section 49 and Section 66 is that both Section 49 and Section 66(1) include acts which are carried on with the intent to defraud creditors. However, while Section 49 requires the deliberate intention to defraud creditors by entering into such transactions, sub- section 2 of Section 66 also punishes negligent acts which affect the interests of the creditors as well. Section 49 also deals specifically with the corporate debtor itself entering into fraudulent transactions while Section 66 punishes any person responsible (sub-section 1) or director/partner (sub-section 2) specifically by imposing personal liability.

Also, Section 49 and 66 doesn't provide any look-back period unlike other avoidance application provisions; hence, any transaction can be looked upon during insolvency proceedings.

Extortionate Credit Transactions

Section 50 of the Code deals with the extortionate credit transactions. As per Section 50, any transaction whose term required exorbitant payments by the corporate debtor would be considered as an extortionate credit transaction. Moreover, the Insolvency and Bankruptcy Board of India may specify which transaction to be considered as extortionate.

Additionally, unlike preferential and undervalued transactions, the lookback period for extortionate credit transactions is two years, regardless of whether the parties are related or not.

In Shinhan Bank v. Sugnil India Private Limited^[14], the Allahabad NCLT analysed the case of extortionate credit transactions.

Background: Shinhan Bank, holding 14.96% voting rights in the Committee of Creditors (COC), challenged the status of other COC members as financial creditors. These members claimed to be financial creditors based on unsecured loans given to the Corporate Debtor with an interest rate of 65% per annum.

Shinhan Bank argued that this interest rate was extortionate and well above market standards. They sought to set aside these debts as illegal credit transactions under Section 50 of the Code. The respondents argued that their transactions with the Corporate Debtor did not qualify as extortionate under Regulation 5 of the IBBI Regulations 2016 and that the interest rates were agreed upon by both parties.

Ruling: The NCLT held that an interest rate of 65% per annum was exorbitant and far above market standards, which generally cap private loan interest at around 24% per annum. Such high interest rates qualified these transactions as extortionate under Section 50 of the Code.

The NCLT emphasized that if the Corporate Debtor is involved in extortionate credit transactions, the Resolution Professional must recognize and avoid these transactions. In this case, the Resolution Professional failed to consider or discuss these transactions, which led the Bench to set aside the debt created from these extortionate credit transactions.

Avoidance Application Can Continue Even after CIRP

The question of whether avoidance application can continue even after completion of the Corporate Insolvency Resolution Process (“CIRP”) has been dealt with by the court in various cases and different answers were given by the courts. However, the position was settled after the ruling of a division bench of Delhi HC in the case of Tata Steel vs. Venus Recruiters.

For example, prior to the Tata Steel judgement, Mumbai NCLT, in the case of State Bank of India v Ushdev International Limited^[15], ruled that avoidance applications cannot be pursued after the approval of the resolution plan.

The tribunal here refers to Regulation 35A of IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016, which mandates that by the 130th day after the insolvency commencement date, the Resolution Professional must apply to the Adjudicating Authority for appropriate relief if there are transactions covered under Section 43, 45, 50 or 66 of the Code.

The tribunal ruled that post-approval of the plan, the Corporate Debtor is managed by new management, and the Resolution Professional becomes functus officio, losing authority to pursue avoidance applications on behalf of the Corporate Debtor. The tribunal rejected the avoidance application, noting that the Resolution Professional could not pursue an avoidance application after the resolution plan's approval and the change in the Corporate Debtor's management.

However, the division bench of Delhi High Court in the landmark case of Tata Steel BSL Limited v. Venus Recruiter Pvt. Ltd. & Ors.^[16], settled the debate. The court ruled that the avoidance application survives even after completion of the CIRP.

In this case, the Resolution Professional filed avoidance applications under various sections of the Code against Venus Recruiter Pvt. Ltd. and others after the completion of CIRP. The NCLT issued notices for these applications, noting they were filed before the resolution plan approval. The Respondents sought a writ from the Delhi High Court to declare the avoidance application proceedings void since the CIRP had concluded and the Successful Resolution Applicant (“SRA”) had taken control of the Corporate Debtor. The Single Judge bench ruled that an application for avoidance of preferential transactions under Section 43 of the Code cannot survive beyond the conclusion of the CIRP. The Corporate Debtor appealed this decision, and the division bench allowed it.

Section 60(5) of the Code talks about the jurisdiction of NCLT. Section 60(5)(c) says that the NCLT has the power to decide on questions arising out of or in relation to the insolvency proceedings. The Bench noted that the phrases “arising out of” or “in relation to” in Section 60(5)(c) of the Code are in broad nature. Applications must be adjudicated by the Authority even if the CIRP has concluded and the SRA has taken over.

The bench ruled that the CIRP and avoidance applications are distinct proceedings. CIRP is time-bound, while avoidance applications require thorough investigation. The Code allows these applications to be addressed independently of the CIRP.

The bench emphasized that avoidance applications prevent beneficiaries of suspect transactions from escaping unscathed. Thus, such applications should be heard even if they were not accounted for in the resolution plan due to timing issues.

Further, the Court ruled that the Resolution Professional continues to have a role in adjudicating avoidance applications and their remuneration should be decided by the Adjudicating Authority.

The Tata Steel/Venus Recruiter case overrules the long-standing stance of courts in this scenario.

Composite Application for Avoidance Transaction

Supreme Court in the Anuj Jain case (supra), dealt with the question of composite application. Here, the material facts pleaded by the Resolution Professional were related to the preferential transaction under Section 43 of the Code. However, he also pleaded that the transaction should be held void under Section 45 and Section 66 of the Code as well. The court here emphasized that the ingredients of preferential transactions are distinct from undervalued and fraudulent, pointing out that the Section 43 is a deeming provisions and legal fiction has to be created pursuant to that. However, that is not the case with the other two transactions. Hence, the court declined to rule on the undervalued and fraudulent transaction and asked the Resolution Professional to plead the specific material facts to seek the remedy under Sections 45 and 66 of the Code.

Supreme Court in the GVR Consulting case (supra) differentiated the Anuj Jain case on facts and held that composite application of PUFE transaction can be made to the Adjudicating Authority, provided that they are filed under separate heads and are substantiated with the specific evidence separately for all the heads.

Similarly, in the case of Star India Private Limited v Advance Multisystem Broadband Communications Limited^[17], the NCLT re-iterated the need for pleading material facts as upheld by the Anuj Jain case. The tribunal rejected the composite application filed by Resolution Professional since specific material facts for Sections 45, 46, 47 or 66 were not pleaded.

In conclusion, a composite application for avoidance transactions can be filed if the allegations and averments are separately made, under different heads.

The concept of avoidance transaction plays and important role in maximising the assets of the Corporate Debtor and eventually helping in protecting the interests of the investors. It also enforces trust and confidence among the investors while making the investment in the jurisdiction that has such a concept. This eventually helps in attracting investment from all around the world.

The jurisprudence surrounding avoidance transactions, including preferential, undervalued, fraudulent, and extortionate credit transactions, has been significantly shaped by landmark judgements by different courts of the country. Cases like Anuj Jain and others have clarified essential elements such as the definition of "ordinary course of business" and the irrelevance of intention in determining preferential transactions. The courts have also emphasised the procedural responsibilities of resolution professionals and the limitations on tribunals to act suo-moto in classifying transactions.

Professionals who are involved in insolvency procedures must have a thorough understanding of the intricacies of these transactions and the applicable legal rules. As the legal landscape continues to evolve, remaining knowledgeable about these essential factors will be vital for practitioners, stakeholders, and policymakers involved in corporate insolvency and bankruptcy.

Views Are Personal.

References:

[1] Jaypee Infratech Ltd. Interim Resolution Professional v. Axis Bank Ltd., (2020) 8 SCC 401