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Speeding Up Insolvency Proceedings & Understanding the Principles of Preferential Transactions

By February 7, 2022July 6th, 2022Blog7 min read
Speeding-Up-Insolvency-Proceedings-_-Understanding-the-Principles-of-Preferential-Transactions

When the commencement of insolvency proceedings takes place, it is essential to prevent distressed companies from taking any measures that could hamper creditors’ recovery. This is critical for the success of insolvency proceedings under any regime. Specific provisions for the protection of creditors and stakeholders need to be in place, especially in the context of the Indian subcontinent.

Creditors, on their part, should use business valuation services to carry out due diligence on borrower companies. With the right valuation services, creditors will be able to get an accurate evaluation of their concerned businesses, as well as their tangible assets.

Many promoter groups holding companies often use opaque structures to hand over the value of assets to other groups so they can derive benefits. The National Company Law Tribunal (NCLT) has the power to undo such transactions so that the interests of the creditors can be protected, under the Insolvency and Bankruptcy Code (IBC), 2016.

There was a recent hearing on the matter of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and others. The SC clarified some critical aspects of Section 43 of the IBC, which deals with preferential transactions in this hearing. These preferential transactions are one of the four ‘avoidable’ transactions under the IBC. By ‘avoidable’ here, we mean that the transactions can be disregarded or annulled. The other three avoidable transactions are extortionate, fraudulent, and undervalued transactions.

In this article, we will discuss these avoidable transactions, taking special note of the elements of preferential transactions. Besides this, we will also take a look at the Supreme Court’s analysis of some critical aspects of the preferential transactions.

Preferential Transactions

Preferential transaction under Section 43 of the IBC is defined in the following way –

  • When the interest or property of the corporate debtor is transferred to benefit the guarantor, surety, or creditor in relation to a past liability.
  • When the guarantor, surety, or creditor acquires a position a benefit by the distribution of assets in case of liquidation (under Section 53 of the IBC)

For a preferential transaction to fall under avoidable transactions, it should have occurred in the following scenario –

  • When the transaction has occurred with the related party in the 2-year’ lookback’ period before the corporate debtor entered into insolvency.
  • When the transaction has occurred in other cases, and it falls in the 1-year’ lookback’ period before the corporate debtor entered into insolvency.

Undervalued Transactions

An Undervalued Transaction under Section 45(2) of the IBC is defined in the following way:

  • When the corporate debtor gifts something to a person.
  • When one or more of assets of the corporate debtor are transferred to a person for consideration.

The value of this consideration is very less as compared to the value of the consideration provided by the corporate debtor. This transaction should not be a part of the corporate debtor’s ordinary course of business.

Transactions Defrauding Creditors

The Transactions Defrauding Creditors, under Section 49 of the IBC, are those undervalued transactions that the corporate debtor deliberately enters into by –

  • Keeping their assets beyond the reach of anyone who can make claims against them.
  • Keeping the assets away so that the interests of the person making claims are adversely affected.

The main difference between transactions defrauding creditors and undervalued transactions is that of ‘intent.’

Extortionate Transactions

Under Section 50 of the IBC, the Extortionate Transactions involve the receipt of operational or financial debt in the 2-year period before the commencement of the insolvency. In avoidable transactions, the ‘transfer’ of assets takes place, while the extortionate transactions are concerned with the ‘receipt’ of credit. The ultimate effect of both these transactions is the same, i.e., the transfer of value outside the corporate debtor.

Supreme Court’s Analysis of Preferential Transactions

Jaypee Infratech Limited (JIL), which was under insolvency, had created mortgages for loans taken by Jaiprakash Associates Limited (JAL), its parent company. In the Jaypee Infratech case, the main issue was whether these mortgages would fall under the avoidable preferential transactions under Section 43, 44 of the IBC. Another issue was whether the JAL lenders could be recognized as the financial creditors for JIL since the loans given to JAL were secured by mortgaging the JIL properties.

Analysis

Before giving the judgment in the case, SC analyzed and highlighted some basic tenets of preferential transactions. It observed that ‘preference’ here, as defined by law, was when the insolvent debtor paid a part or whole of their claims to a creditor, in exclusion of the rest. In a detailed analysis of Section 43 of the IBC, the SC said that a transaction would be considered preferential in the following cases:

1. When there was a transfer of property by the corporate debtor to benefit the creditor to pay off a financial debt owed to the creditor.

2. When the creditor acquired a beneficial position through the transaction. This advantageous position would typically not be possible during the liquidation waterfall, which is provided under Section 53(ii) of the IBC.

3. These transactions took place –

  • With the related party in the 2-year’ lookback’ period before the corporate debtor entered into insolvency.
  • In other cases, and fall in the 1-year’ lookback’ period before the corporate debtor entered into insolvency.

The transactions would be excluded from the scope of preferential transactions on the following grounds:

  • When the transaction or transfer took place in the ordinary course of financial affairs or business of the corporate debtor.
  • When the transaction secures a value in the corporate debtor’s acquired property in terms of goods, monetary value, services, or new credit.

Judgment

The SC upheld that the mortgage created by JIL contained all the properties of a preferential transaction under the IBC. It noted that –

  • There was a transfer of property/interest to benefit the creditor.
  • The transfer was done because of an antecedent liability or debt owed by the debtor.
  • The transfer was done to benefit the related party within the lookback period.
  • The transfer was not done in the ordinary course of financial affairs or business.

Key Takeaways

Before entering into a transaction with a company, it is crucial for the creditors and contracting parties to ensure that they obtain the latest financial records of the company. If there are any signs of financial distress, the risk of carrying out a transaction should be weighed heavily or avoided.

Our business valuation services can help creditors greatly in this respect. Whether for any valuation and business verification exercises, our team of experts is ready to assist you. To know more about our valuation services, contact us today! We are here to provide expert services for all your valuation needs.

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