Avoidable transactions in IBC

Avoidable transactions in IBC

Author: Mr. Anand Shelke is a 5^th year B.A.LL.B (Hons) student at Sandip University in Nashik

Introduction:

The Insolvency and Bankruptcy code was a major reform in the Indian capitalism market. The IBC shifts debtor is control to creditor in control. The objective of the code is to recovery of debt in a time-bound manner, maximization of assets, promote entrepreneurship, safeguard the interest of the stakeholders and revival of the company. The object is carried out by a procedure called corporate insolvency resolution process (CIRP). One of the goal of the CIRP is to maximize the assets of the company in financial distress. Therefore, the CIRP must prevent any situation that could reduce the value of the company. The concept of a moratorium, which temporarily halts other recovery proceeding against the company, is based on the idea that the company’s valuation should not decrease during the CIRP. In line with the objective of maximizing asset value for creditors, the IBC includes provisions to ensure that any necessary or fraudulent transaction that accrued prior to the CIRP and could diminish the company’s value are canceled or avoided.

Avoidable transaction:

To ensure the effectiveness of an insolvency system, it is crucial to prevent financially distressed companies from taking actions that could hinder the recovery of their creditors if insolvency proceedings were to occur. This becomes particularly significant in India, where companies are frequently owned by promoter groups who might attempts to transfer asset value through complex arrangement to other companies within the group for their personal gain. The  NCLT possesses the power to reverse such transactions with the aim of protecting the interests of creditors and other stakeholders. Avoidance transactions refer to financial deals carried out by a debtor that place creditors at a disadvantage or favor certain creditors over others. These transactions are typically conducted prior to the debtor facing insolvency and therefore raise questions about their validity. They are also known as irregular, avoidable, or vulnerable transactions. Examples include the dilution of assets by the debtor, transferring assets to related parties or affiliated companies, engaging in fraudulent deals, and giving preferential treatment to certain creditors, thereby devaluing assets. With the implementation of the Insolvency and Bankruptcy Code (IBC) in 2016, avoidance transactions have been classified as offenses. The IBC includes provisions that allow such deals to be nullified or rendered ineffective. The parties involved in the irregular trade should be held accountable for the recovery of any transferred assets or their corresponding realized value. This helps to maximize the assets available to creditors during the insolvency process.The avoidance of transaction in simple terms means any transaction which is done in the interest of a creditor or any other 3^rd party, usually done before the initiation of the CIRP. It is the duty of the resolution professional or liquidator to report such avoidable transaction to the adjudicating authority, if the professional fails to report, disciplinary proceedings will initiate against him.

There are 4 types of transactions under IBC:

1. Preferential transactions
2. Undervalued transactions
3. Transaction defrauding creditors
4. Extortionate transactions

The responsibility of examining such transactions, where creditors were intentionally disadvantaged, falls upon the resolution professional and the liquidator. An application must be submitted to the adjudicating authority to reverse these deals. The assets recovered or the equivalent recovered amount is then included in the liquidation estate. According to the IBC, the personal assets of management and promoters are generally not eligible to be included in the insolvency proceedings, except in cases where they were transferred through avoidance transactions.

Preferential transaction:

A preferential transaction refers to a specific type of transaction where a debtor favors a particular person or corporate entity. To qualify as preferential, two conditions must be met:

a) The debtor transfers property or interest to a creditor in relation to a prior financial or operational debt.

b) The transfer results in the creditor gaining a more advantageous position than they would have had in the liquidation process.

Transactions that occur as part of regular business operations or those involving assets used to secure a debt are not considered preferential. For instance, in a liquidation scenario, unsecured creditors typically have lower priority compared to secured creditors. However, if the debtor transfers an asset to an unsecured creditor for a past debt, the unsecured debt becomes secured, granting the creditor higher priority during liquidation. Such a transaction would be classified as preferential.To manage practicality and feasibility, a”look-back period” is defined under the Insolvency and Bankruptcy Code (IBC) to determine which transactions can be scrutinized for avoidance. The look-back period for preferential transaction is :

a) 2 years when related parties are involved.

b) 1 year for all other parties.[1]

This means that debtors cannot challenge preference transactions that occurred more than 2 years ago involving related parties or more than 1 year ago involving other parties, for example.

Undervalued transaction:

Undervalued transactions refer to cases where a debtor transfers an asset for a significantly low consideration. To ensure transparency, debtors should have clear transfer pricing policies in place. An undervalued transaction occurs if any of the following conditions are met:

1. The asset is gifted to a person or corporate entity.

B) The asset is sold for an amount significantly lower than its acquisition cost.[2]

However, regular business transactions are not considered undervalued transfers as long as they are conducted on an Arm’s Length Basis. It is important to flag undervalued deals to prevent improper reduction of the debtor’s Net Asset value.Similar to preference transactions, undervalued transactions are subject to a look-back period, which precedes the insolvency commencement date. Only transactions within this period can be reviewed for avoidance. The look-back period is:

1. 2 years when related parties are involved.
2. 1 year when other parties are involved.[3]
3. This means that no application can be filed for transactions that occurred before this defined window.

Transaction defrauding creditors:

            These transactions refer to deliberately undervalued transactions entered into by a corporate debtor with the intention of either keeping their asset out of reach from those who have a legitimate claims  against them or negatively impacting the interest of such claimants. The key difference between undervalued transactions and transaction defrauding creditors lies in the element of intent. While intent is not relevant in undervalued transactions, it must be proven to the satisfaction of the NCLT for a transaction to be considered fraudulent. Another important distinction is that there is no specific time period for examining fraudulent transactions, as fraud taints everything.

            One significant consequence of a transaction being classified as fraudulent is the potential penalty it carries. According to sec 69 of the IBC, officers of a company involved in fraudulent transactions may be subject to imprisonment for up to five years and a fine of up to one crore rupees. However, undervalued transaction do not have a prescribed penalty under the IBC.[4]

Extortionate transaction:

            Extortionate credit transactions refer to situations where a borrower obtains a financial or operational debt but is subjected to exorbitantly high payment conditions. These terms can include high interest rates, demanding valuable assets as collateral, or unfavorable repayment conditions. For instance, it is common for companies to borrow from promoters at interest rates significantly higher than market rates. While banks may lend at 10-15% interest, promoters might lend at rates like 20-25%.

However, if the debt has been extended by a financial institution in compliance with the law, such transactions are not considered extortionate. This can occur in the case of zombie companies with poor financials, where banks and non-banking financial companies (NBFCs) lend at high interest rates and require collateral. Therefore, these transactions cannot be classified as extortionate.Similar to preference and undervalued transactions, a look-back period is defined under the Insolvency and Bankruptcy Code (IBC) for extortionate credit transactions. This period precedes the insolvency commencement date, and only transactions within this time-frame can be reviewed for avoidance. In the case of extortionate credit transactions, the look-back period is 2 years.[5]

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Conclusion:

            The IBC also includes provisions to address any necessary or fraudulent transactions that occurred prior to the CIRP and could diminish the value of the company. These transactions, known as avoidable transactions, refer to deals carried out by a debtor that disadvantage creditors or favor certain creditors over others. The National Company Law Tribunal (NCLT) has the authority, as per the IBC, to reverse such transactions in order to protect the interests of creditors and stakeholders. Avoidance transactions are considered offenses under the IBC, and the Code allows for the nullification or ineffectiveness of such deals. Any assets that have been transferred or their corresponding value, whether realized or not, must be retrieved from the individuals or entities implicated in these irregular transactions. This helps maximize the assets available to creditors during the insolvency process.In summary, the IBC aims to prevent financially distressed companies from taking actions that could hinder creditor recovery. It includes provisions to cancel or avoid avoidable transactions, which are deals conducted prior to insolvency that disadvantage creditors. These provisions help maximize the assets available for distribution among creditors during the CIRP.

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[1]The Insolvency and Bankruptcy Code, 2016, Act No.13 of 2016, sec 43

[2]The Insolvency and Bankruptcy Code, 2016, Act No.13 of 2016, sec 45

[3]The Insolvency and Bankruptcy Code, 2016, Act No.13 of 2016, sec 46

[4]The Insolvency and Bankruptcy Code, 2016, Act No.13 of 2016, sec 49

[5]The Insolvency and Bankruptcy Code, 2016, Act No.13 of 2016, sec 50