India: Avoidance Of Specified Transactions Under Insolvency And Bankruptcy Code, 2016

Whenever a person is declared as insolvent, certain transactions undertaken during the process of insolvency or even before that are avoided to overturn their effects on the finances of the corporate debtor. The provisions are generally called as 'avoidance provisions' and are present in insolvency laws of almost all jurisdictions. They ensure that the value of assets of the company is maximized and all the creditors get their dues in an equitable manner. These provisions aim at setting aside transactions which are preferential in nature. Section 536 and 537 of Companies Act, 1956 provides for avoidance of transfers, certain attachments, executions, etc. after commencement of winding up. Similarly, Sections 328-331 of Companies Act, 2013 provide for avoidance of certain transaction undertaken before or after the commencement of winding up proceedings.

The recent I&B Code, 2016 (hereinafter, 'the Code') also includes detailed provisions with respect to avoidance of certain transactions. Clause (j) of Section 25(2) casts a duty on the Resolution Professional to file application for avoidance of transactions, if there is any. The application is to be filed in accordance with Chapter III of Part II of the Code. The application for avoidance may be filed during both Corporate Insolvency Resolution Process and Liquidation Process. Sections 43-51 of the Code deal with avoidance of certain transactions. The transactions are divided into three categories: preferential transactions, undervalued transactions and extortionate credit transaction. For avoiding or setting aside the transactions there is a "relevant period" which is prescribed under various provisions of the code. Transactions undertaken during this "relevant period" only can be avoided.

Preferential Transaction

Certain transactions may be avoided under sections 43 of the Code if it appears that they have been preferred over others. The liquidator or the resolution professional has to make an application to the Adjudicating Authority for avoidance of such transactions where he is of the opinion that they have been preferred. In addition to this, sub-section 2 of section 43 of the Code lists down certain transactions which shall be deemed to have been given a preference. It covers transaction where there is a transfer of property or an interest in respect of an existing debt or liability, and such transfer has the effect of putting such creditor in a beneficial position than it would have been in the event of a distribution of assets u/s 53 of the Code. But any transfer which is made in the ordinary course of business or which creates a security interest in the property acquired by the corporate debtor shall not be a preferential transaction.1

The relevant time for preferential transaction is two years preceding the insolvency commencement date, if it made to a related party and one year if it is made to a person other than a related party.2 Related party is someone who is related to the entity, in this case corporate debtor, in one way or the other. Section 5(24) of the Code provides a list of people who are taken as related party for the purposes of this code. On receiving an application for avoidance of preferential transaction, the Adjudicating Authority may pass following orders:3

  1. vesting, in the corporate debtor, of transferred property or the property which represents the application of proceeds of transferred property;
  2. release or discharge of any security interest created by the corporate debtor;
  3. require a person to pay such amount in respect of benefit received by him;
  4. direct any guarantor to be under new or revived debts, whose earlier debts were released preferentially;
  5. direct for subjecting any property under charge for discharge of any financial or operational debt;
  6. direct for providing the extent to which a person, whose property is so transferred or on whom debts have been imposed, can prove his debt in the insolvency process or the liquidation process.

Undervalued Transaction

According to Section 45(2) of the Code an undervalued transaction is one where corporate debtor makes a gift or transfers one or more assets for insignificant consideration, provided that such transaction has not taken place in the ordinary course of business of the corporate debtor. Also, the resolution professional or the liquidator can make an application to the Adjudicating Authority with respect to preferential transactions u/s 43(2) of the Code, if they find them to be undervalued and made during the relevant period.

The relevant period for avoiding a transaction at undervalue is given under section 46 of the Code. For transaction made with a related party the relevant period is two years preceding the insolvency commencement date, and for transactions made with any other person this period is one year preceding the insolvency commencement date.

Furthermore, in case of undervalued transactions, right is also given to a creditor, member or partner of a corporate debtor to make an application to Adjudicating Authority, if the liquidator or the resolution professional has not reported the same. After examination of the application if the Adjudicating Authority is satisfied that the liquidator or the resolution professional, despite having sufficient information did not report such transaction, they can pass an order requiring the Board to initiate disciplinary proceedings against them.

The effect of the application is that the transactions are declared void and the effects are reversed. The Adjudicating Authority may pass the orders under section 48 of the Code of following nature:

  1. require any property transferred as part of the transaction, to be vested in the corporate debtor;
  2. release or discharge (in whole or in part) any security interest granted by the corporate debtor;
  3. require any person to pay such sums, in respect of benefits received by such person, to the liquidator or the resolution professional as the case may be, or
  4. require the payment of such consideration for the transaction as may be determined by an independent expert.

Extortionate Credit Transactions

Extortionate credit transactions are the credit transactions which involve the receipt of financial or operational debt to the corporate debtor. They are termed as extortionate because the terms are either unconscionable, or require the corporate debtor to make exorbitant payments in respect of the credit provided.4 However, a debt which is in compliance with any law for the time being in force in relation to such debt shall in no event be considered as an extortionate credit transaction.5

Whenever, an application for avoidance of credit transactions are made to the Adjudicating Authority, it has to satisfy itself that the terms require exorbitant payments to be made by the corporate debtor. Where it is so satisfied, the Adjudicating Authority can make the following orders with respect to the transactions:

  1. restore the position as it existed prior to such transaction;
  2. set aside the whole or part of the debt created on account of the extortionate credit transaction;
  3. modify the terms of the transaction;
  4. require any person who is, or was, a party to the transaction to repay any amount received by such person; or
  5. require any security interest that was created as part of the extortionate credit transaction to be relinquished in favour of the liquidator or the resolution professional, as the case may be.

Thus, the provisions for avoidance of transactions make sure that the transactions, which have no commercial purpose otherwise, and have been undertaken only to benefit some creditors or to hamper the process of insolvency or liquidation, are set aside. The provisions help to correct the situation when a certain transfer of property is made merely to keep the property away from the pool of assets to be divided among the creditors. However, the principles of avoidance are to be exercised cautiously so that valid transactions undertaken in the normal course of business are not reversed.

Footnotes

1 Section 43 of I&B Code, 2016.

2 Section 43(4) of I&B Code, 2016.

3 Section 44 of I&B Code, 2016.

4 Regulation 5 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016.

5 Explanation to section 50(1) of the Code, 2016.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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