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R. Haritha

B.B.A. LL.B., Fourth Year
VIT School of Law
Chennai Campus

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Related Party under the Insolvency and Bankruptcy Code (IBC)

Related Party under the Insolvency and Bankruptcy Code (IBC)

An exhaustive, yet precise and unambiguous definition as to who a related party is, concerning a Corporate Debtor, is critical to ensure that no mischief slips through the cracks when it comes to avoidance transactions. For avoidance transactions entered into by a Corporate Debtor, the IBC provides a comprehensive and exhaustive list of persons and entities, which are “related parties” of the Corporate Debtor.


The definition stipulated in the Code is constructed to be limited from the perspective of the corporate debtor. Before the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2018, there was no definition for an individual- this gap has been filled by the Ordinance, 2018, however, there is still nothing in the Code as regards related party of a company or body corporate (other than corporate debtor). In such a scenario, since Section 3(37) of the Code provides that for words/expressions not defined in the Code, the definitions given in the Companies Act, 2013 will be applicable, the definition under Section 2(76) of the Companies Act, 2013 becomes relevant.


As per Section 2(76)(iv) of the Companies Act, 2013, if a director of the company is a member or director of the other company, that other company becomes a related party. A similar clause is reflected in Section 5(24)(d) of the Code as well, though it is constructed solely from the perspective of the corporate debtor.


It will also be relevant to mention here that Section 5(24)(m) of the Code is drafted most widely, and indicates that the stance of the draftsman is on the reality of inter-relationships between the two entities. If the two entities are operating under common control, the indicia as given in Section 5(24)(m) will apply. Thus, interchange of personnel, participation in policy-making, or provision of technical information are indicators of the association of the two entities. It is not necessary that the company in question must be a supplier of technical information, or must be participating in policy-making or would cause inter-change of personnel. If there is a common source of control over both the entities, resulting in these circumstances, it cannot be denied that the two entities become “associated” for that reason.


This discussion is also relevant for determining who will constitute a part of the committee of creditors, particularly regarding the first proviso to Section 21(2) of the Code. The intent of Section 21(2) of the Code in denying voting rights to related parties is to ensure that the corporate insolvency resolution process is driven by external creditors. Even though related parties may have claims, and may even file for the corporate insolvency resolution process, such parties cannot drive the insolvency resolution process, as that would be rife with conflicts of interest. Such awholesome intent cannot be rendered infructuous by giving a narrow or technical interpretation to the meaning of the term.


PREFERENTIAL TRANSACTIONS


Preferential Transactions are essentially transactions where “an insolvent debtor makes a transfer to or for the benefit of a creditor so that such beneficiary would receive more than what it would have otherwise received through the distribution of bankruptcy estate.”


The use of the term “preference” here is to denote the act of ‘paying or securing to one or more of his creditors, by an insolvent debtor, the whole or part of their claims, to the exclusion of the rest”. As far back as the 15th century, the principles relating to avoidance of certain preferences have evolved, particularly in mercantile laws and insolvency/ bankruptcy laws. In fact, since 1874, almost all jurisdictions across the world have incorporated provisions for identifying and avoiding preferential transactions into their bankruptcy/insolvency laws. The UNCITRAL Guide defines a “preferential transaction” as “a transaction which results in a creditor obtaining an advantage or irregular payment”.


In India, the legal position of the identification and avoidance of preferential transactions under IBC are set out in Sections 43 and 44 of the IBC. Under Section 43 of the IBC, a transaction entered into by the Corporate Debtor is said to be a preferential transaction if some ingredients are satisfied.


The Supreme Court of India in the matter of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited etc., REED 2020 SC 02502 has laid down the key principles for identifying preferential transactions as follows:

  • The Supreme Court distinguished Section 43 of the IBC from Sections 328 and 329 of the Companies Act, 2013 and observed that if the ingredients of Section 43 of the IBC (as set out above) are satisfied, then the transaction is deemed to be a preferential transaction, notwithstanding the intent of the parties;

  • The bare text of Section 43(3)(a) of the IBC stipulates that a transaction is exempt from being treated as a preferential transaction if it was carried out in the ordinary course of business or financial affairs of the Corporate Debtor or the transferee. However, the Supreme Court observed that a purposive interpretation of Section 43 demands that the phrase “Corporate Debtor or transferee” should be interpreted as “Corporate Debtor and transferee”. In other words, the Supreme Court observed that for a transaction not to be considered as a “preferential transaction” such transaction is required to have been undertaken in the “ordinary course of business” or “financial affairs” not only of the transferee but also of the Corporate Debtor;

  • The phrases “ordinary course of business” and “financial affairs” are not defined in the IBC. The Supreme Court has applied the interpretation of the High Court of Australia in the matter of Downs Distributing Co Pty Ltd. v. Associated Blue Star Stores Pty Ltd. (inliq), (1948) 76 CLR 463, where it was held that “ordinary course of business” means “that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation.” However, it is relevant to note that the Supreme Court did not interpret the meaning of the phrase “financial affairs” for Section 43 of the IBC.

  • For determining whether an alleged transaction entered into by a Corporate Debtor with its related party was conducted in the “ordinary course of business” of the Corporate Debtor, the Supreme Court analysed the unique nature of the relationship between the Corporate Debtor and its related party. For instance, the Supreme Court inter-alia observed that the Corporate Debtor (being a special purpose vehicle) mortgaging its assets to secure the borrowings of its parent company cannot be construed to be in the ordinary course of business of such corporate debtor.


UNDERVALUED TRANSACTIONS


The UNCITRAL Guide defines “undervalued transactions” as “Transactions where the value received by the debtor as the result of the transaction with a third party was either nominal or non-existent, such as a gift, or much lower than the true value or market price, provided the transaction occurred within the suspect period.”


These transactions may be entered into by the Corporate Debtor either with a mala fide intention of causing wrongful gain to its related parties at the expense of its other stakeholders; alternatively, in a situation wherein a Corporate Debtor who needs cash may sell assets quickly at a price significantly below the real value to achieve a quick result, without ever having any intention to defeat or delay creditors. However, in either of these cases, the net result may be a clear reduction of the assets available to creditors in insolvency.


The National Company Law Tribunal, Allahabad Bench has held in the matter of IDBI Bank v. Jaypee Infratech Ltd., CA No. 26/2018 in Company Petition No. (IB) 77/ALD/2017 that a transaction can be said to be an undervalued transaction if the consideration for entering into the transaction was significantly lower than what it would have otherwise been had it been entered at an arm’s length basis.


It is relevant to note that like in preferential transactions, a transaction is exempt from being treated as an “undervalued transaction” if such transaction was carried out in the ordinary course of business of the Corporate Debtor.


UNDERVALUED TRANSACTIONS TO DEFRAUD CREDITORS


Under the IBC, an undervalued transaction in terms of Section 45(2) of the IBC is the one to keep assets of the Corporate Debtor beyond the reach of any person who is entitled to claim against the Corporate Debtor or to adversely affect the interests of such person is treated differently. In the case of undervalued transactions within the meaning of Section 49 of the IBC, there is no Lookback Period for determining whether such transactions have taken place, and the RP/liquidator is required to.


EXTORTIONATE CREDIT TRANSACTIONS


A transaction would be considered as an “extortionate credit transaction” if such contracts require the Corporate Debtor to make exorbitant payments in respect of the credit provided, or are unconscionable under the principles of law relating to contracts.


In the event the Corporate Debtor has entered into such a transaction, the liquidator or the RP as the case may be may make an application for the avoidance of such transaction to the Adjudicating Authority if the terms of such transaction required exorbitant payments to be made by the Corporate Debtor. It is relevant to note that unlike in the case of preferential transactions or undervalued transactions, the Lookback Period is two years, regardless of whether the counterparty is a related party or unrelated party.


WRONGFUL TRADING/FRAUDULENT TRADING


A transaction can be termed as wrongful trading/fraudulent trading if during the CIRP or a liquidation 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.


If the Adjudicating Authority adjudges transaction to be wrongful trading/fraudulent trading, then it may 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.


As to whether a transaction can be considered as “fraudulent trading” or “wrongful trading” depends on the facts and circumstances of each case, and is a subjective assessment of whether it can be demonstrated that the transaction was entered into to defraud the creditors of the Corporate Debtor.


In the case of transactions under Section 66 of the IBC, there is no Lookback Period for identifying transactions that could be considered wrongful trading/fraudulent trading. However, given that the nature of the transaction, it is typically only persons in the management of the Corporate Debtor who could orchestrate a transaction to defraud creditors.


Therefore, in case the Adjudicating Authority determines that a transaction has taken place within the meaning of Section 66 of the IBC, it may direct that a director or partner of the corporate debtor (who qualify as the Related Parties of such Corporate Debtor), shall be liable to make such contribution to the assets of the Corporate Debtor as it may deem fit, if:

  • before the ICD, 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 a director or partner did not exercise due diligence in minimising the potential loss to the creditors of the corporate debtor.

If the Adjudicating Authority adjudges a transaction as a fraudulent transaction then it may inter-alia direct that the liability of any person found guilty of committing wrongful trading/fraudulent trading 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. Additionally, if the Adjudicating Authority has passed an order about a person who is a creditor of the Corporate Debtor, it may direct that the whole or any part of any debt owed by the Corporate Debtor to that person and any interest thereon shall rank in the order of priority of payment under Section 53 after all other debts owed by the Corporate Debtor.


CONCLUSION


The threat of related parties diluting the value of the Corporate Debtor, whether during the lookback period of 2 years before the insolvency commencement date, during the CIRP or even through payments and benefits under a resolution plan is sufficiently guarded against by a host of safeguards under the IBC. The robust framework for identifying avoidance transactions entered into with related parties and provisions to protect the interests of stakeholders of a Corporate Debtor is at the very heart of achieving one of the most important objectives of IBC - the resolution of insolvency while also ensuring maximisation of the value, preservation of the assets of the Corporate Debtor and safeguarding the interests of all stakeholders of the Corporate Debtor.

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