Whenever an entity become an insolvent, certain transactions are to be avoided otherwise it will affect the financial position of the entity. These transactions are called avoidable transactions.
The idea behind the concept of avoidable transactions is that the basic objective of the code is to maximization of the value of assets, availability of credit, improve entrepreneurship and equitable distribution of assets to all stakeholders and achieve the resolution in a time bound manner. To achieve this objective, the corporate debtor that is the company which has availed credit facility from the creditors, should avoid certain financial transactions which will affect the very basic objective of the code. These transactions are called avoidable transactions. The entity should avoid these transactions either during the insolvency resolution period or before certain period.
This concept is existing earlier also. The section 536 and 537 of companies act 1956 deals with avoidable transactions .Section 328 to 331 of companies Act 2013 deals with similar provisions. In Insolvency and Bankruptcy code 2016 , the similar provisions were incorporated. The corporate debtor should avoid these transactions only during the relevant period .The code has imposed an obligation on the insolvency professional to file an application for avoidance transactions as per section 25(2) (j).The duty casts on the Resolution Professional to form an opinion on avoidable transactions on or before 75 th day of commencement of corporate Insolvency resolution period determine on such transaction on or before 115 th day and file application about such transactions with Adjudicating authority on or before 135 th day of commencement of insolvency resolution period .
As per the Insolvency and Bankruptcy code 2016, section 43 to 51 deals with avoidable transactions. These transactions are also called as vulnerable transactions .As per the code; there are three types of avoidable transactions. Such are preferential transactions, Undervalued transactions and extortionate credit transaction the corporate debtor has to avoid these transactions during the relevant period.
The section 43 of insolvency and bankruptcy code deals with preferential transaction. The section provides for avoidance of preferences given by the corporate debtor during or before commencement of insolvency resolution process. The section tries to strike off the transactions which will disturb the pari passu distribution of assets during the liquidation process.Thus subject to certain exceptions, the section tries to invalidate the transaction involves transfer of property or interest thereof given during the relevant time to a person for the benefit of a creditor, surety or guarantor on account of antecedent debt or other liabilities which have the effect of putting such creditor, surety or guarantor in a better positon which he would have been in if such transfer has not been made.
Section 43 states that the effect of the transaction is to put the recipient in a position more beneficial than would have been the case under section 53.
As may be inferred from section 43 (2), in order to establish that the transaction is a ‘preferential transaction’, it is important to bring the following to the fore –
(i) There is “a property or an interest in the property” of the corporate debtor”;
(ii) Such property is “transferred”;
(iii) The transfer operates for the benefit of a creditor or a surety or a guarantor
(iv) The transfer is for or on account of an antecedent debt (operational/financial) or other liabilities, owed by the corporate debtor;
(v) The transfer has the effect of putting the beneficiary in a better position that it would have been if assets were distributed in accordance with section 53 of the Code
Let us illustrate. Say, A lent money to B without any security. If B were to be liquidated on insolvency, A’s priority would have been lower in the staking order, and A will stand at lower end due to unsecured creditor and as such the possibility of A getting back all its money would have been very low. However, subsequently, B creates security interest in favour of A. Once security interest is created A become secured creditor, which improves the position of A in the event of liquidation of B. As such, creation of security interest has resulted in betterment of A.This is preference transaction.
A transaction is considered to be a preferential transaction if the following conditions are fulfilled
(a) Transfer of property happens for the benefit of creditor / surety / guarantor; and
(b) Such transfer puts the creditor in beneficial position than what he would have been obtained, in the event of distribution of assets.
Exclusions of Preference:
The following are not considered to be in Preference:
1. Transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee;
2. 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.
From the above, we can infer that the following transfers will not considered as preference transactions
1. The suppliers of goods and services who have supplied goods and services to the corporate debtor during the normal course of business or ordinary course of business of the corporate debtor and such corporate debtor made payment to such suppliers. This payment will not be considered as Preference transaction
2. The following will not be considered as Preference transaction
a) Transfer of security interest by the corporate debtor creates new value
b) That was given at the time of or after signing of a security interest agreement contains the description of such property as security interest
c) Was used by the corporate debtor to acquire such property
d) Such transfer was registered with information utility on or before thirty days after the corporate debtor receives possession of such property
Take an example. Lent money to B. A is an existing creditor of B. Later, A demands that a charge be created on B’s assets against the money lent. The security interest does not create a “new value”.
Second example: A lent money to B. Later, in order to pay A, B takes loan from C and creates a charge on its property for C. There is no “new value” involved.
Third example: A lent money to B against a charge on the assets of B. B takes loan and acquires a technology for its assets under charge to A. B has acquired a “new value” by creating security interest in favour of A (note that here, whether the technology was acquired or not is immaterial).
Besides “new value”, the security interest, so as to avail exemption from being called a preference, shall also fulfill the following conditions – (i) The security interest should be given at the time of or after signing of a security agreement; (ii) The security agreement should contain a description of the property as “security interest”; (iii) The security interest was used by the corporate debtor to acquire such property; (iv) The transfer was registered with an information utility on or before 30 days after the corporate debtor receives possession of such property.
3. Any transfer made in pursuance of order of court can also be considered as making of preferential transaction by the corporate debtor. Any order by the court enforcing the terms and conditions of the contract does not mean that such transfer shall be excluded from the meaning of preferential transaction under the code
1. with related party – 2 years preceding the insolvency commencement date.
2. with others – 1 year preceding the insolvency commencement date.
Look-back period is the period the transactions up to which may only be challenged. The look-back period under section 43 is 2 years preceding the insolvency commencement date (in case the preference is given to a related party) and 1 year preceding the insolvency commencement date (in case the preference is given to a party other than a related party). Basically, the distinction has to be made between an “inside creditor” and an “outside credit
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 (i.e. National Company Law Tribunal or NCLT in short) for avoidance of preferential transactions and for, one or more of the orders referred to in section 44.
Transaction is considered to be undervalued when:
1. Gift is given; or
2. Transfer the asset for consideration which is significantly less than the consideration provided by the CD
3. Above transaction is not in ordinary course of business.
1. with related party – 2 years preceding the insolvency commencement date.
2. with others – 1 year preceding the insolvency commencement date.
The making of gift to a person by the corporate debtor is considered as an undervalued transaction.
The other category of undervalue transaction is
1. Corporate debtor enters into a transaction with another person.
2. This transaction involves transfer of property from corporate debtor to such person.
3. The Value of consideration for the transaction is much lower than the provided in the books (or)
The value fetched is much lower than the value which is provided by the corporate debtor .This transaction is called under value transaction
The Resolution professional or liquidator whenever such transaction has come across, he has to make an application to the tribunal for declaring such transaction as null and void and reverse the effect of such transaction
Transactions defrauding creditors section 49
Section 49 of IBC 2016 deals with the provisions of transactions defrauding the creditors .The section speaks about the transactions entered into by the corporate debtor with intention of putting the assets of the corporate debtor beyond the reach of creditors or otherwise prejudice the interest of the person who is making claim against the corporate debtor or he may make claim in near future against the corporate debtor. The specialty of section 49 is that there is no time limit for challenging against the transaction in the Tribunal unlike in other avoidable transactions where the time limit is one year for persons and two years for related party transactions.
The important element required for attracting section 49 is that there should be deliberate act on the part of corporate debtor to enter into an under value transaction . This transaction was entered into with an intention to keep the assets of the corporate debtor beyond the reach of any person who is entitled to make a claim against the corporate debtor or adversely affect the interest of such person.
If Resolution professional or liquidator has noticed this transaction, he can make an application to the adjudicating authority, which in turn, on satisfaction, passes on order for
a) Restoring the positon as it existed before such transaction as if the transaction has not been entered into and
b) Protecting the interests of the persons who are victims of such transactions
The following transactions will not attract section 49. They are
1. Interest in property was acquired from a person other than the corporate debtor
2. Acquired in good faith
3. without the knowledge or notice of relevant circumstances of corporate debtor.
Distinction between section 45 and 49
Both sections that are section 45 and section 49 pertains to the avoidance transactions. The only difference between the two is that section 49 deals with undervalued transaction undertaken with a malafide or wrongful intention. But whereas for section 45 no such element is required. The look back period is provided for section 45 but no such look back period for section 49 because once a fraud always a fraud . The idea behind the provision is that any person who has done any act with malafide intention cannot get away by citing reason such as lapse of time .
Section 50 speaks about the extortionate credit transactions. Extortionate means exorbitant, excessive or severe. If the corporate debtor obtains any credit facility with exorbitant rate of interest or unfair credit terms such as incorporating severe default provision or was in a vulnerable positon at the time of the transaction. To attract the section, exorbitant payment to be made in respect of provision of credit or where it is grossly contravened fair principles of lending .The second condition which attracts section 50 is such lending are unconscionable under the principles of law relating to contracts .The examples of unconscionable under the principles of law are signing agreement without reading the contents, signing the contract under intimidation or concealing the important conditions under small letters or interest is charged without lending money are some of the examples.
The only exception for section 50 is if the credit facility is extended by any person providing financial services which is in compliances with any law for the time being in force in relation to such debt. Then such transaction will not be considered as extortionate credit transaction.
Time limit for avoiding extortionate credit transaction is two years preceding the date of insolvency commencement date .On application filed by Resolution Professional or liquidator, the adjudicating authority will order for
A) Restore the positon as it existed prior to such transaction
B) Set aside the whole or part of the transaction of debt
C) Modify the terms of transaction
D) Require any person who is a party to the transaction to repay any amount received
E) Relinquish the security interest created out the transaction in favour of liquidator or resolution professional
In addition to the above avoidable transactions, the directors of the company should be very cautious about the section 66 which is to be avoided during and before commencement of insolvency resolution process. The section 66 is having two parts. section 66(1) deals with fraudulent trading and section 66(2) deals with wrongful trading. Originally these provisions were not there in the companies Act and it was imported from UK legislation.
Hence both fraudulent trading and wrongful trading are provided in section 66 which is divided into sub sections.
Section 66(1) says liability on any person who are knowingly parties to the carrying any business with a dishonest intention to defraud creditors. From the above we can infer the following
1. The section applicable not only to internal persons like Directors, partners, employees but also applicable to outside persons.
2. The person who is entering into the transaction should have a knowledge that there is no reasonable prospect of repaying the debt
3. There should be a dishonest intention to defraud the creditors.
If the resolution professional has proved in front of Tribunal, the Tribunal will direct the person to make contribution to the assets of the corporate debtor. Hence it is very important section for Resolution professional to book fraudulent activities of both internal and external people to defraud the creditors. Here there is no look back period.
Section 66(2) directs liability only on Directors and partners of company if
1) Directors know or ought to have known that there was no reasonable prospect of avoiding the commencement of corporate insolvency resolution process
2) Directors or partners have failed to exercise due diligence in minimizing the potential loss to be incurred by the creditors
Hence Directors under this section can be punished even if they do not have element of dishonest intention but acted negligently and recklessly there by exposing the company to a further loss. Directors cannot plead ignorance of knowledge under this section .It is the responsibility of directors to ensure that as far as possible the interest of all stake holders are to be taken care off and also to ensure that the loss of the corporate debtor should not increase during the insolvency period . Hence Directors should exercise extra care during the period that there is no reasonable prospect of avoiding commencement of resolution of company till the time the company actually enters into resolution. Further Directors should not do any act which will further reduce the value of assets.
From the above, we can infer the following
1. Directors have knowledge of no reasonable prospect of avoidance of resolution
2. Directors have failed to exercise due diligence
Distinction between section 66(1) and 66(2)
|S.No||Nature of transaction||Section 66(1)||Section 66(2)|
|1||Liability||Section covers both internal and external people||Section covers only internal people|
|2||Activity||Section covers fraudulent trading when business functioning normally||Section covers duties of Directors during insolvency period|
|3||Nature of trading||Fraudulent trading||Wrongful trading|
|4||Necessary element||Element of Knowledge along with dishonest intention is required||Element of negligence is required|
|5||Punishment||Both civil and criminal||Liable only under Civil|
If the transaction is proved as above, the Adjudicating authority will order that debt or part of debt owed to defrauded creditor shall rank in the order of priority of payment under section 53 after all other debts owed by corporate debtor. In addition to this , punishment under criminal law may also be imposed .
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