Introduction
The Insolvency and Bankruptcy Code (IBC) acknowledges the legal rights of stakeholders and the transactions entered into by the Corporate Debtor (CD) before the initiation of Corporate Insolvency Resolution Process (CIRP). However, under specific circumstances, these transactions can undergo scrutiny, questioning, and potential reversal, a process known as ‘avoidance.’ Certain types of transactions fall under the scope of investigation by the Resolution Professional (RP) and the liquidator. In cases where the RP or liquidator hasn’t reported them to the Adjudicating Authority (AA), creditors, members, or partners of the CD can also apply for the annulment of such transactions. This is rooted in the principle of restitution, particularly in preventing unjust enrichment. It revolves around two key principles in insolvency law: (1) the pari passu principle, ensuring equitable treatment of unsecured creditors during CIRP, and (2) defining the assets considered part of the CD’s estate.[1]
Furthermore, recognizing the responsibility of the CD’s directors and officers towards creditors and other stakeholders, provisions exist for seeking contributions from them if the CD engaged in improper (fraudulent or wrongful) activities that caused losses to creditors.
Additionally, to facilitate the smooth progression of insolvency and liquidation proceedings, the IBC categorizes certain actions taken by creditors, directors, and officers of the CD as ‘offenses,’ subject to corresponding penalties.
Avoidance Transactions
The UNCITRAL Legislative Guide on Insolvency Law defines avoidance provisions as “provisions within insolvency law that allow for the cancellation or rendering ineffective of asset transfers or obligations undertaken prior to insolvency proceedings. This enables the recovery of assets transferred or their equivalent value for the collective benefit of creditors”.[2] Avoidance provisions represent a crucial instrument in insolvency law, serving the purpose of maximizing the assets of the Corporate Debtor (CD) and thwarting opportunistic and value-depleting actions undertaken by the CD or certain creditors prior to the initiation of insolvency proceedings. The overarching objective is to safeguard the CD’s pool of assets for the mutual benefit of all stakeholders. While the criteria for avoidance may vary depending on the nature of the action, in general, transactions that can be subject to avoidance involve situations where the CD has diluted its assets or conferred an unfair advantage or undue enrichment upon specific creditor(s).
The underlying principle behind avoiding these transactions is to safeguard the broader body of creditors, ensuring that no particular creditor gains an unfair advantage at the expense of others, and to optimize the overall pool of assets available to creditors during the insolvency resolution and liquidation process.
The authority to “avoid” such transactions lies with the Adjudicating Authority (AA), which can initiate this process based on an application submitted by the Resolution Professional (RP) or the liquidator. It’s important to note that as per section 36(3)(f)[3] of the IBC, any assets or their value recovered through avoidance proceedings become part of the CD’s liquidation estate. Section 36(4)[4] further clarifies that the personal assets of shareholders or partners of a CD are exempt from the liquidation estate, provided they are not held as a result of transactions that can be avoided under the IBC. Consequently, avoidance transactions play a pivotal role in maximizing the liquidation estate of the CD.
According to section 25(2)(j)[5] of the IBC, it is the responsibility of the RP to file an application for the avoidance of transactions in accordance with Chapter III if applicable. Similarly, section 35(1)[6] of the IBC grants the liquidator the authority and obligation to investigate the financial affairs of the CD to identify undervalued or preferential transactions. In addition to these provisions, specific sections of the IBC addressing avoidance transactions (such as sections 43, 45, 50, and 66) necessitate the filing of appropriate applications by either the RP or the liquidator, as the case may be, before the AA in relation to such transactions.
The IBC recognizes several types of avoidance transactions collectively referred to as PUFE transactions in its framework, including: preferential transactions, undervalued transactions fraudulent transactions and extortionate transactions”. We will be dealing only with Preferential Transactions in this article.
Preferential Transactions
Sections 43 and 44 within the IBC pertain to preferential transactions.
Section 43 of the IBC [7]outlines that if the liquidator or the RP believes that, during the “relevant time,” the Corporate Debtor (CD) has shown favoritism toward any individual or entity in a transaction, they must seek the Adjudicating Authority’s (AA) intervention for the issuance of one or more orders detailed in section 44 of the IBC.[8]
What Is a “Preference”?
As per section 43(2), a CD shall be deemed to have given a preference if the following two conditions are satisfied:[9]
- There is a transfer of property (or an interest thereof) of the CD for the benefit of a creditor, surety, or guarantor, for or on account of an antecedent financial debt or operational debt or other liabilities owed by the CD.
- This transfer has the effect of putting such creditor, surety, or guarantor in a more beneficial position than they would have been in the event of a distribution of assets being made in accordance with section 53 of the IBC.[10]
Hence, any transfer for the benefit of a creditor, surety or guarantor, which is done for and on account of an antecedent liability owed by the CD, which improves the position of such creditor, surety or a guarantor in the liquidation waterfall set out in the section 53 of the IBC would be a preference.
To give an example, financial debts owed to unsecured creditors rank under paragraph (d) of the section 53(1) waterfall mechanism.[11] If a security is given by the CD to its unsecured creditor for securing a financial debt that was taken from the unsecured creditor in the past (that is, for or on account of antecedent financial debt), such unsecured creditor would become secured and then fall under paragraph (b)(ii) of the section 53(1) waterfall mechanism. Since the transaction (that is, grant of security) would place the creditor in a better position in case of distribution under section 53, such a transaction would amount to a preference being given by the CD to the creditor.”
What Is “Relevant Time”/the Look- Back Period?
For a preference to be avoided, it should have been given at the relevant time. As per section 43(4) of the IBC[12], a preference shall be deemed to be given at a relevant time if:
- it is given to a related party (other than by reason only of being an employee), during the period of two years preceding the ICD;
- a preference is given to a person other than a related party during the period of one year preceding the ICD.
The “relevant time” is the “look-back period.” Only preference given during such period can be avoided.
The reason for avoiding preference transactions is to prevent a situation where a creditor, surety, or guarantor gains an unfair advantage over other creditors during the period just before the initiation of Corporate Insolvency Resolution Process (ICD). This period, known as the twilight period, occurs when the Corporate Debtor (CD) is already under financial strain, insolvent, or on the brink of insolvency. It is crucial during this phase to maintain the priority of creditors and avoid a rush among creditors to collect their debts. The Insolvency and Bankruptcy Code (IBC) establishes clear criteria for defining this twilight period concerning preference transactions, which is generally set at one year before the ICD. However, when preference is extended to a related party, who typically possesses better knowledge of the CD’s financial situation, the period is extended to two years before the ICD.
Exceptions
There are two exceptions to “preference” recognized in the IBC. Under section 43(3) of the IBC, a preference does not include the following:[13]
- a transfer made in the ordinary course of the business or financial affairs of the CD;
- any transfer creating a security interest in property acquired by the CD to the extent that:
- 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 the CD to acquire such property; and
- such transfer was registered with an IU on or before 30 days after the CD receives possession of such property.
“New value” means money, or its worth in goods, services, or new credit, or a release by the transferee of property that was previously transferred to such transferee in a transaction that is neither void nor voidable by the liquidator or the RP under the IBC, including proceeds of such property, but does not include a financial debt or operational debt substituted for existing financial debt or operational debt.
Notably, any transfer made in pursuance of a court order will not preclude such transfer to be deemed as giving of preference by the CD.
The reason behind making an exemption for transactions conducted in the usual course of business is to ensure that customary and standard payments and routine transactions carried out by the Corporate Debtor (CD) during the relevant period, in order to maintain the company’s regular operations, remain unaffected. For example, regular rent payments to landlords or routine payments to suppliers are examples of transactions that fall within the normal course of business operations.
Orders That Can Be Passed for Preferential Transactions
Section 44 of the IBC[14] delineates the types of orders that the Adjudicating Authority (AA) can issue when an application regarding preferential transactions is submitted. These orders may include, among other things, the transfer of ownership of the property related to the preference; transfer of property (if it represents the utilization of proceeds from property sales) that was transferred, or money that was transferred; elimination of any security established as a preference; repayment of amounts related to benefits received by the recipient from the Corporate Debtor (CD); instructing any guarantor whose debts were favored with release or discharge due to the preference to assume such new or revived debts as the AA deems appropriate, and so forth.
To protect persons who have received any benefit from preference in good faith and for value, it has been clarified that an order under section 44 “shall not:
(a) affect any interest in property acquired from a person other than the CD, or any interest derived from such interest, acquired in good faith and for value;
(b) require a person who received a benefit from the preferential transaction in good faith and for value to pay a sum to the liquidator or the RP.”
The explanations to section 44 further clarify that unless the contrary is shown, it shall be presumed that the interest was acquired or the benefit was received otherwise than in good faith if “such person:
(a) had sufficient information of the initiation or commencement of the CIRP of the CD (and a person shall be deemed to have sufficient information or opportunity to avail such information if a public announcement regarding the CIRP has been made under section 13 of the IBC);
(b) is a related party.”
Conclusion: In conclusion, the Insolvency and Bankruptcy Code (IBC) plays a crucial role in protecting the rights of stakeholders and maintaining fairness during Corporate Insolvency Resolution Process (CIRP) and liquidation proceedings. The concept of avoidance transactions, particularly preferential transactions, is a pivotal aspect of this framework.
Preferential transactions are those transactions made by a Corporate Debtor (CD) that give an unfair advantage to certain creditors, sureties, or guarantors during the period just before the initiation of CIRP. The IBC defines specific criteria for identifying such transactions, including the transfer of property for the benefit of a creditor, surety, or guarantor, and the improvement of their position compared to other creditors.
The “relevant time” or look-back period is crucial in determining whether a transaction qualifies as preferential. Generally set at one year before the initiation of CIRP, this period can extend to two years if the preference is given to a related party, ensuring that those with better knowledge of the CD’s financial situation do not gain an undue advantage.
However, the IBC also provides exceptions, recognizing transactions made in the ordinary course of business and those creating security interests under specific conditions. These exemptions safeguard routine business operations and legitimate security interests from being classified as preferential.
The Adjudicating Authority (AA) holds the power to issue various orders when dealing with preferential transactions, including the transfer of ownership, elimination of security interests, and repayment of benefits received by the recipient. Importantly, the IBC protects persons who have received benefits in good faith and for value, ensuring that they are not unfairly penalized.
In essence, preferential transactions are a critical aspect of the IBC aimed at maintaining fairness and equitable treatment of creditors, thereby upholding the fundamental principles of insolvency law. By identifying and addressing such transactions, the IBC maximizes the assets available for distribution among creditors, ultimately promoting the successful resolution of corporate insolvency cases.
[1] Understanding the IBC Key Jurisprudence and Practical Considerations, https://ibbi.gov.in/uploads/whatsnew/e42fddce80e99d28b683a7e21c81110e.pdf ( last visited Sep. 14, 2023).
[2] Legislative Guide on Insolvency Law, UNCITRAL, https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf (last visited Sep. 14, 2023).
[3] The Insolvency and Bankruptcy Code, 2016, § 36(3)(f), No. 31, Acts of Parliament, 2016 (India).
[4] The Insolvency and Bankruptcy Code, 2016, § 36(4), No. 31, Acts of Parliament, 2016 (India).
[5] The Insolvency and Bankruptcy Code, 2016, § 25(2)(j), No. 31, Acts of Parliament, 2016 (India).
[6] The Insolvency and Bankruptcy Code, 2016, § 35(1), No. 31, Acts of Parliament, 2016 (India).
[7] The Insolvency and Bankruptcy Code, 2016, § 43, No. 31, Acts of Parliament, 2016 (India).
[8] The Insolvency and Bankruptcy Code, 2016, § 44, No. 31, Acts of Parliament, 2016 (India).
[9] The Insolvency and Bankruptcy Code, 2016, § 43(2), No. 31, Acts of Parliament, 2016 (India).
[10] The Insolvency and Bankruptcy Code, 2016, § 53, No. 31, Acts of Parliament, 2016 (India).
[11] The Insolvency and Bankruptcy Code, 2016, § 53(1), No. 31, Acts of Parliament, 2016 (India).
[12] The Insolvency and Bankruptcy Code, 2016, § 43(4), No. 31, Acts of Parliament, 2016 (India).
[13] The Insolvency and Bankruptcy Code, 2016, § 43(3), No. 31, Acts of Parliament, 2016 (India).
[14] supra. at 8.
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