Avoidable Transaction under IBC: Key Factors

The fundamental goal of the Insolvency and Bankruptcy Code is to maximize asset value, credit availability, increase entrepreneurship, and equitable asset distribution to all stakeholders while completing the resolution in a timely manner and during the CIRP phase or before a specified period, the corporate debtor is prevented from indulging in such type of transactions for the benefit themselves which could hamper the recovery process. Basically, whenever an entity becomes insolvent, there are certain transactions that are to be avoided otherwise it would affect the financial position of the entity and that’s why these transactions are called avoidable transactions. The other name for such types of transactions is vulnerable transactions.

The idea of avoidable transactions has been around for a long time and have been addressed in sections 536 and 537 of the Companies Act of 1956 as well as similar rules to be found in sections 328 to 331 of the Companies Act 2013. Thereafter, similar measures were included in the Insolvency and Bankruptcy Code wherein only during the relevant period the corporate debtor should avoid these transactions. 

It is to be noted that section 25(2)(j) of the code, states that the insolvency professional is required to file an application for avoidance transactions. And, the Resolution Professional is required to form an opinion on avoidable transactions on or before the 75th day of the commencement of the corporate insolvency resolution period, to decide on such transactions on or before the 115th day, and to file an application with the adjudicating authority on or before the 135th day of the beginning of the insolvency resolution period.

Sections 43 to 51 of the Insolvency and Bankruptcy Code 2016 deal with avoidable transactions. According to the code, there are four types of transactions that can be avoided namely preferential transactions, undervalued transactions, the transaction’s defrauding creditors and exorbitant credit transactions are the transactions that a corporate debtor must avoid during the relevant period. The Supreme Court had given guidance on certain aspects of such transactions in the case of Jaypee Infratech and a few key considerations for the parties to mitigate the risk of their transactions falling within the ambit of such avoidable transactions are briefly looked upon as well. 

PREFERENTIAL TRANSACTIONS

A transaction is described as a preferential transaction under Section 43 of the Bankruptcy Code if it involves the transfer of the corporate debtor's property or interest for the benefit of a creditor, surety, or guarantor in relation to an antecedent or a past liability and if it has the effect of giving such creditor, surety, or guarantor a beneficial position in the distribution of assets in the event of liquidation under Section 53 of the Code.

Furthermore, any such preferential transaction must have occurred either within a "look back" period of two years immediately preceding admission of the corporate debtor into insolvency in the case of a transaction with a related party; and within a "look back" period of one year immediately preceding admission of the corporate debtor into insolvency in any other case. The transactions in the regular course of the corporate debtor's or transferee's business or financial operations that result in the production of new value for the corporate debtor are exempted, even if they occur within the aforementioned look back periods.

In the recent case of Jaypee Infratech, the key issue before the Supreme Court was whether certain mortgages created by Jaypee Infratech Limited which is the company under insolvency for loans availed by its parent company Jaiprakash Associates Limited amounted to preferential transactions avoidable under sections 43 and 44 of the IBC. The JAL and its proponents contended that the mortgage's beneficiaries were the creditors who had created the mortgages and that the "look-back" period should be one year which is applicable in the case of transactions with unrelated parties. However, the court determined that such transactions were for the benefit of a related party (subject to a two-year "look-back" period) because they permitted JAL to obtain much more funding from a wider number of creditors. The Supreme Court also clarified the exclusion of transactions conducted in the ordinary course of business from the ambit of preferential transactions liable to be set aside - transfers made in the ordinary course of the corporate debtor or transferee company's business or financial affairs would not fall within the ambit of preferential transactions liable to be set aside, according to section 43(2) of the IBC and also held that the term "or" in such a provision must be understood as "and."

Based on the scheme and objectives of the Bankruptcy Code, the court determined that the relevant consideration for the purposes of section 43 is the corporate debtor's conduct and affairs and that transactions that appear to minimize the potential loss to other stakeholders in the corporate debtor's affairs, particularly its creditors, should be ignored. As a result, even if a preferential transaction is carried out in the usual course of the transferee company's business, it will be considered as a preferential transaction as long as it is not carried out in the ordinary course of the corporate debtor's business.

The Supreme Court concluded that a transaction could be classed as an "ordinary course of business" only if it was part of an "undistinguished general flow of business done" and did not emerge out of "any special or particular condition." As a result, even though a company's typical business practice would be to provide security, it would not be considered a transaction in the "ordinary course of business".

Therefore, the observations made by the Supreme court has clarified certain fundamental aspects of preferential transactions under Section 43 of the code in the case of Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and Others, REED 2020 SC 02502, wherein like discussed above the preferential transactions are one of the four types of avoidable transactions that can be annulled or ignored, the others being undervalued, extortionate, or fraudulent transactions.

UNDERVALUED TRANSACTIONS

A transaction is considered undervalued under section 45(2) of the IBC if the corporate debtor makes a gift to a person or enters into a transaction with a person that involves the corporate debtor in transferring one or more assets for a consideration that is significantly less than the value of the consideration provided by the corporate debtor, and the transaction is not in the corporate debtor's ordinary course of business.

 In simple terms, the amount fetched is significantly less than the amount provided by the corporate debtor then this type of transaction is known as an undervalued transaction. And, when a resolution expert or liquidator encounters such a transaction, then he or she must file an application with the tribunal to have the transaction declared null and void and the effect reversed.

Hence, any transaction in the ordinary course of business of the corporate debtor would not amount to an undervalued transaction, just as it would not amount to an undervalued transaction in the case of preferential transactions. The undervalued and preferred deals have the same "look-back" time and accordingly, the guidance issued by the Supreme Court in the case of Jaypee Infratech like discussed earlier on these aspects would apply in the context of undervalued transactions as well.

TRANSACTION’S DEFRAUDING CREDITORS 

The provisions of transactions defrauding creditors related are addressed in section 49 of the Insolvency and Bankruptcy Code. This section discusses transactions made by a corporate debtor with the intent of putting the corporate debtor's assets beyond the reach of creditors or otherwise prejudicing the interests of the person making a claim against the corporate debtor or who may make a claim against the corporate debtor in the near future. The unique feature of section 49 when looked upon is that there is no time limit for contesting the transaction before the Tribunal, unlike the other avoidable transactions, which have a one-year time limit for individuals and a two-year time limit for connected parties.

Purposeful conduct on the part of the corporate debtor to enter into an undervalue transaction is a key need for attracting section 49. This transaction was made with the objective of keeping the corporate debtor's assets out of the hands of anyone who might be able to bring a claim against it or who might harm the corporate debtor's interests. And, if a Resolution professional or liquidator notices this type of transaction, he can file a complaint with the adjudicating authority, which, if satisfied, would issue an order restoring the situation to the way it was before the transaction, and make it as if the transaction never happened, by protecting the interests of those who are victims of such transactions as well.

Section 49 of IBC will, however, not apply to the transactions when property interest was obtained from someone other than the corporate debtor, or purchased with good confidence or without knowledge or notice of the corporate debtor's relevant conditions.

After analyzing the provisions so far, it is essential to understand that section 45 and section 49 both deal with avoidance transactions but the main distinction is that section 49 is concerned with undervalued transactions carried out with malafide or unlawful purpose and no such element is required under section 45. Likewise, section 45 has a look back period, but section 49 does not, because once fraud is committed, it is committed forever. The rationale behind the clause is that anyone who has committed a criminal act with malice in mind cannot get away with it by invoking a justification like the passage of time.

EXTORTIONATE TRANSACTIONS

An extortionate transaction is defined as the receipt of financial or operational debt within two years after the insolvency beginning date at terms requiring the corporate debtor to make extravagant payments, which may be avoided by an order of the adjudicating authority under Section 50 of the IBC. Unlike the other avoidable transactions such as those stated above, which focus on the transfer of assets by the corporate debtor, the extortionate transactions focus on the receipt of credit by the corporate debtor, even when the end result is the transfer of value outside of the corporate debtor.

The credit obtained by the corporation at unreasonably high-interest rates is an example of an extortionate credit transaction and the NCLT, New Delhi bench judged the agreed rate of interest of 65 percent per year to be an extortionate transaction in the case of Shinhan Bank v. Sugnil India Private Limited and others (Company Petition No. IB- 492/ND/2018 and Company Application No. 184/2018) and even went on to say that in most private loans, the parties agree to a maximum interest rate of 24 percent per year.

The extortionate credit transactions like said are addressed in Section 50 which refers to something that is excessive, extreme, or severe. It is if the corporate debtor receives a credit facility with an excessive rate of interest or unfair credit terms, such as a punitive default clause, or if the debtor was in a vulnerable position at the time of the transaction.

 The extortionate payment to be made in respect of credit provision or when it is substantially in violation of fair lending norms attracts this section and the second criterion that invokes section 50 is that such lending is unconscionable under contract law principles. So, signing a contract without understanding the contents, or signing a contract under duress, concealing crucial clauses in small print, or charging interest without lending money are all examples of unconscionable behaviour under the principles of law.

The only exception for section 50 of the code is if the credit facility is extended by any person providing financial services which are in compliance with any law for the time being in force in relation to such debt, then such transaction will not be considered as an extortionate credit transaction.

After having discussed the types of avoidable transactions we see that in addition to the above avoidable transactions, the directors of the company should also be very cautious about section 66 which is to be avoided during and before the commencement of the insolvency resolution process. Section 66 is divided into two parts as section 66(1) that deals with fraudulent trading and section 66(2) deal with wrongful trading. 

Section 66(1) says liability on any person who is knowingly parties to the carrying of any business with a dishonest intention to defraud creditors. The section is applicable not only to internal persons like directors, partners, employees but also applicable to outside persons. Secondly, the person who is entering into the transaction should have knowledge that there is no reasonable prospect of repaying the debt and there should be a dishonest intention to defraud the creditors. If the resolution expert has proven his or her worth in front of the tribunal, the tribunal will order the person to contribute to the corporate debtor's assets. As a result, it is critical for Resolution professionals to keep track of both internal and external personnel who are attempting to defraud the creditors and there is no lookback period.

Section 66(2) directs liability only on directors and partners of a company if the directors know or ought to have known that there was no reasonable prospect of avoiding the commencement of corporate insolvency resolution process and if the directors or partners have failed to exercise due diligence in minimizing the potential loss to be incurred by the creditors. 

In conclusion, we see that the transactions that may be avoidable under the Insolvency and Bankruptcy Code are generally related to a period of up to two years prior to the commencement of a corporate debtor's insolvency. As a result, contracting parties and creditors must verify that they have access to a firm's most recent financial position before engaging in any transaction, especially those involving the transfer of assets or value from the company. If there are any indications of economic difficulties, the risk of avoiding a transaction should be carefully assessed and weighed. 

The other important thing to be noted is that the persons who participated in preferential or fraudulent transactions in good faith and for value are protected by the provisions relating to preferential and fraudulent transactions with the additional requirement of lack of notice of the relevant circumstances in the case of fraudulent transactions. In order to be eligible for such protection, the contractual parties or the lenders should make sure that there is sufficient documentation proving that the transaction was for fair value and that it was carried out after reasonable care and investigation into the company's activities. Therefore, whether a transaction falls within the scope of any of the IBC's avoidable transactions should undoubtedly be included in the checklist of items for investigation by the parties prior to engaging in any significant transaction.

The Supreme Court case Jaypee Infratech like discussed in detail in this article clearly states that the investigation for each of the avoidable transactions under the IBC is different, and that particular relevant fact would have to be pled to prove that a transaction fits into each of these categories and thus, the parties should consider their transaction in light of the precise requirements that apply to each of the categories of avoidable transactions in order to avoid falling foul of any such regulation at a later point of time.