Delving further into Preferential Transactions: NCLAT studies section 43 in light of Jaypee ruling, SC upholds

– Shaivi Bhamaria | resolve@vinodkothari.com

When a corporate person undergoes Corporate Insolvency Resolution Process (‘CIRP’) or liquidation process, there is an obvious presumption of precedent financial stress, and hence, all the transactions that have an adverse bearing on the financial health of the distressed corporate person, at the cost of stakeholders, come under the scanner. There is a look-back period, which, based on global equivalents, has been fixed at 2 years prior to commencement of CIRP in case of transactions with related persons, and 1 year prior to commencement of CIRP in other cases. The Insolvency and Bankruptcy Code, 2016 (‘the Code’) has titled such transactions as ‘avoidance transactions’. Such avoidance transactions are classified into 4 categories in the Code, viz- (a) preferential transactions (b) undervalued transactions (c) transactions defrauding the creditors and (d) fraudulent transactions. The provisions with respect to avoidance transactions are inspired by the UK Insolvency Act.

While the Code has specified the rules to identify and classify transactions as preferential or otherwise, the courts have, time and again, looked for the underlying spirit. This is not unusual, because any potential defaulter will be under tremendous pressure prior to onset of insolvency, and will devise ingenious ways of creating preferences and hiving off value. Therefore, adjudicating bodies all over the world have taken the scope of avoidance transactions based on the test of intent, rather than the precise language of the law. With brains at work to wriggle out of the language of the law while devising transactions, it will be a pity if the very language becomes the limit as to the scope of the law when insolvency sets in.

Some of the major rulings on the scope of avoidance transactions are M/s. Venus Recruiters Pvt. Ltd. Vs. Union of India & Ors^[1], Anuj Jain, IRP for Jaypee Infratech Limited Vs. Axis Bank Ltd. & Ors. and others.

 Recently, in its judgement dated April 24, 2023 in the matter of GVR Consulting Services Private Limited v. Pooja Bahry (erstwhile Resolution Professional of NTL Electronics India Private Limited ^[2], the Hon’ble National Company Law Appellate Tribunal (‘NCLAT’) has given some clarity on certain aspects of ‘Preferential Transactions’ while relying of the landmark judgement of the SC in the matter of Anuj Jain, IRP for Jaypee Infratech Limited Vs. Axis Bank Ltd. & Ors. (2020) 8 SCC 401^[3]. The ruling of NCLAT was subsequently upheld by SC^[4], thereby re-enforcing the observations the SC made in Anuj Jain.

Before we delve into the details of the various aspects of the order of the NCLAT, let us first understand what constitutes ‘Preferential Transactions’

What are preferential transactions?

As defined under section 43 (2) of the Code, a transaction will be said to be ‘preferential’ if:

1. It involves a transfer of property or an interest in the property of a Corporate Debtor (‘CD’)
2. for the benefit of a creditor/ surety/ guarantor
3. on account of an antecedent financial debt/ operational debt /other liabilities and
4. Such a transfer has the effect of putting the said creditor/ surety/ guarantor in a beneficial position than it would have been in the event of a distribution of assets being made in accordance with section 53.

That is to say, when pursuant to a transaction a creditor is put in a beneficial position with that of the other creditors on account of repayment of debts, such a transaction may be classified as a preferential transaction. Even if a transfer is made in pursuance of the order of a court the same can be deemed as preferential.

It can be seen that section 43 provides for the avoidance of preferences given by the CD in the run up to CIRP/ insolvency. This provision is intended to strike at transactions which disturb the pari passu distribution of assets in the CIRP/ liquidation of a CD. Subject to the exceptions provided, it invalidates any transfer of property or interest thereof given during the relevant time to a person for the benefit of a creditor/ surety/ guarantor on account of antecedent debt or other liabilities which have the effect of putting such creditor/ surety/ guarantor in a better position than the position which he would have been in if such transfer had not been made^[5].

Section 43 (4) also provides for a look back period for identifying such preferential transactions. The look back period is a period prior to commencement of the CIRP. If a transaction that satisfies the criteria as above, falls within the look back period, the Resolutional Professional (‘RP’) of the CD can file an application before the relevant bench of the Hon’ble National Company Law Tribunal (‘NCLT’) to avoid such a transaction. The look back period prescribed under the Code is –

1. If preference is given to a related party: two years preceding the commencement of CIRP; or
2. If preference is given to other than a related party: one year preceding the commencement of CIRP

With respect to the look back period a longer time period has been provided for preference given to related parties. This is important for avoiding such transactions as a number of transactions diminishing creditor wealth entered into with related parties occur not only in the ‘zone of insolvency’ but as soon as early signals of trouble are visible. Related parties often have superior information of the CD’s financial affairs and may collude with the CD to siphon off assets with the knowledge that the CD may become insolvent in the near future^[6].

The Code also provides for exceptions by way of sub-section (3) of section 43:

1. transfer made in the ordinary course of the business/ financial affairs of the CD or the transferee;
2. any transfer creating a security interest in property acquired by the CD to the extent that –
3. 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 CD to acquire such property; and
4. such transfer was registered with an information utility on or before thirty days after the CD receives possession of such property:

It is to be noted that it is immaterial whether the ordinary course of business or financial affairs is that of the corporate debtor or the transferee, such a transfer would be excluded from the purview of preferential transactions. A transaction in the ordinary course of business must usually also be in arm’s length transaction. If the transaction is in ordinary course of business, but not done on arm’s length basis, it may certainly be treated as an undue preference.^[7]  

Preferential transactions have also been defined in a similar manner by the UNCITRAL Legislative Guide on Insolvency Law (‘UNCITRAL Legislative Guide’). Para 177 of the UNCITRAL Legislative Guide lays down the following parameters for identifying preferential transactions:

1. the transaction has taken place within the specified suspect period;
2. the transaction involves a transfer to a creditor on account of a pre-existing debt; and
3. As a result of the transaction, the creditor has received a larger percentage of its claim from the debtor’s assets than other creditors of the same rank or class.

Ingredients for invoking section 43

There are three ingredients to attack a transaction under section 43:

1. Recipient was a creditor, surety or a guarantor for or on account of an antecedent financial or operational debt or other liabilities owed by the CD. There must be a liability for payment to a creditor – gratuitous payments are not covered here.
2. The effect of the transaction is betterment. Section 43 (2) (b) 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. This being the case of an insolvent entity, there would have been a strong possibility of the recipient not being paid in full – the loss depending on the stacking order where the recipient will fall. Here it must be noted that the law says ‘effect of putting such creditor.’ Hence what matters is the effect of the payment and not the intent or motivation.
3. The transaction is not covered by the carve-outs given in section 43 (3)^[8]

Why was the concept of avoidance transactions included in Insolvency Laws?

The rationale for bringing in the concept of avoidance transactions in insolvency laws has been explained in paras 151, 152 and 153 of part II, F of the UNCITRAL Legislative Guide.

As per the UNCITRAL Legislative Guide, in insolvency collective action is more efficient in maximising the assets available to creditors than a system that leaves creditors free to pursue their individual remedies. Provisions dealing with avoidance of transactions are designed to support these collective goals, ensuring that creditors receive a fair allocation of an insolvent debtor’s assets consistent with established priorities and preserving the integrity of the insolvency estate. Further, avoidance provisions also have a deterrent effect i.e. they discourage creditors from pursuing individual remedies in the period leading up to insolvency if they know that these may be reversed or their effects nullified on commencement. Avoidance provisions are also important because these provisions of this nature help to create a code of fair commercial conduct. Many of the transactions that are subject to avoidance are perfectly normal and acceptable when they occur outside that context, but become suspect only when they occur in proximity to the commencement of insolvency proceedings.

The Ruling in Pooja Bahry Case:

Facts of the matter are outlined below:

NTL Electronics India Ltd. – the Corporate Debtor was admitted into CIRP by order dated August 27, 2019 of the Hon’ble NCLT, Delhi Bench and Ms. Pooja Barhy was appointed as RP by the Committee of Creditors (‘CoC’). The RP appointed a transaction auditor to conduct the audit of the CD for the period April 01, 2016 to August 27, 2019 (‘the look back period). Pursuant to the findings in the report of the transaction auditor regarding certain transactions undertaken by the CD, an avoidance application was filed by the RP pursuant to the consent of the CoC.

The transactions that amounted to Rs. 6.37 crores mainly pertained to payments by the CD to certain parties (related and unrelated) that were claimed to be repayment of unsecured loans.

The Hon’ble NCLT held that the transactions entered into by the CD with the respondents were preferential transactions and directed that the respondents refund the amount. Aggrieved by the said order, appeals were filed by the respondents before the Hon’ble NCLAT.

Questions that arose for consideration of NCLAT were:

1. Whether intention is essential in identifying a transaction as preferential?
2. Whether a transaction undertaken under pressure of lenders will be considered as a preferential transaction?
3. What will be considered an ‘ordinary course of business’?
4. Whether a composite application can be filed for various avoidance transactions?

The deliberation of NCLAT are discussed below:

1. Whether intention is essential in identifying a transaction as preferential?

During the course of the appeal, the NCLAT was called upon to determine whether a transaction will be termed as preferential even though the same was not carried out with the intention of giving preference to a particular creditor. The NCLAT placed heavy reliance on the view taken by the SC in Anuj Jain, IRP for Jaypee Infratech Limited v.. Axis Bank Ltd. & Ors. (‘Anuj Jain’), and held that if the elements laid down in section 43 (2) coupled with the timeframe as mentioned in section 43 (4) are satisfied a legal fiction comes into play.

Once the legal fiction comes into play, the relevant transaction entered into by the CD will be deemed as a preferential transaction irrespective of whether the transaction was in fact intended or even anticipated to be so.

2. Whether a transaction undertaken under pressure of lenders will be considered as a preferential transaction?

Another submission made by the Appellants was that the said transactions under the pressure of notice and threat of initiating proceeding under Section 138 of the Negotiable and Instrument Act, the and hence cannot be termed as preferential transactions. It was the submission of the appellants that a preferential transaction is voluntary and a transaction that is carried out under pressure and threat cannot be called as such. The NCLAT stated that the proviso to section 43 (3) provides 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.’ The intention of the legislature is clearly brought out by the said proviso. Where the law mandates that a transfer made in pursuance of order of Court cannot be an exception to such a transfer being labelled ‘preferential’ there is no room for considering any transaction made in pursuance to a notice/ demand/ threat issued by a lender.

The intent of the CD is not relevant since section 43 creates a legal fiction. Whether the transaction is voluntary or not has no relevance while coming to the conclusion that the same is a preferential translation.

3. What will be considered an ‘ordinary course of business’?

It was the contention of the appellants that the transactions that the RP has allegedly termed as preferential were in fact only repayment of loans taken by the CD from the some of the appellants and were hence carried out in the ordinary course of business of the CD and were hence covered under the exception laid down in section 43 of the Code.

In order to determine what constitutes an ‘ordinary course of business’ the NCLAT placed reliance on the UNCITRAL Legislative Guide and the judgement of the SC in the Anuj Jain matter.

As per para 165 of the UNCITRAL Legislative Guide the term ordinary course of business must be used in order to determine what constitutes routine conduct of business and allows a business to make routine payments and enter into routine contracts, without subjecting those transactions to possible avoidance in insolvency. Such routine payments can include the payment of rent, utilities such as electricity and telephone and possibly also payment for trade supplies.

The SC in the matter of Anuj Jain has used the Mischief Rule of interpretation of statues in determining what constitutes an ‘ordinary course of business’ and stated that while deciding whether or not a particular transaction would come in the scope of ‘ordinary course of business’, the object and purpose of section 43 of the Code and the legislative scheme and the intention of the legislature be kept in mind. The word “or” as used in 43(3) should be read as “and” so as to be conjunctive of the two expressions i.e., “corporate debtor” and “transferee”, that is, a preference shall not include the transfer made in the ordinary course of the business or financial affairs of the corporate debtor and the transferee. As held by the High Court of Australia in the judgement of Downs Distributing Co. Pty Ltd. v. Associated Blue Star Store Pty. Ltd.^[9], “It means that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation”

The NCLAT, stating application of the Anuj Jain ratio in this case, concluded that the CD in question was engaged in the business of manufacturing and electronics component and projects and hence taking financial assistance from related and non-related parties cannot be held to be in ordinary course of business of the CD. The NCLAT was of the view that the words ‘ordinary course of business’ and ‘financial affairs’as stated in sub-section 3 of section 43 be read ‘ejusdem generis’ and their meaning cannot be extended to subsume within it all financial transactions done by the Corporate Debtor. NCLAT remarked that, “Money arranged from relatives and other parties by the Corporate Debtor thus cannot be held to be part of ordinary course of business or part of financial affairs”.

However, the author is of the humble opinion that businesses are often involved in taking financial assistance from unrelated as well as related parties. Hence, such activities are normal in business. What might render it “not ordinary” and “preferential” is that certain creditors are given priority over other creditors so as to accord them benefits which they otherwise are not entitled to. Hence, giving and receiving of financial assistance may be a part of ordinary course, but making preferential repayments may make it not ordinary. The facts in Anuj Jain were different as it was about creating mortgage on properties for the benefit of the holding company, where the financial health of the subsidiary itself was dwindling – this, certainly, puts a question mark on the “ordinary” nature of the transaction. However, from the facts appearing in the instant NCLAT order, it is not clear whether the CD was making disorderly/preferential repayments, and it appears that the Hon’ble NCLAT has based its decision solely on classification of “taking financial assistance” as not in ordinary course of business. Given that SC has upheld the NCLAT ruling, the aforesaid observations made by NCLAT might appear to be conclusive. However, in the humble opinion of the author, the issue might be specific to the facts of the instant case, and the applicability of such observations to other cases may be subject to particular facts and circumstances.

4.  Whether a composite application can be filed for various avoidance transactions?

The appellants also contended that a composite application was filed by the RP under section the relevant provisions of the Code for various types of avoidance transactions raising allegations against several party under different provisions of the Code was not maintainable in view of the law laid down by the SC in the matter of Anuj Jain.

The NCLAT clarified that the SC has in the matter of Anuj Jain emphasised that ingredients of section 43, 45 etc. are different and an RP must take the said requirement into consideration while making an application to the NCLT. A composite application where the allegations and averments are separately made, under different heads, does not suffer from any infirmity.

Concluding remarks:

Avoidance transactions are often disguised as simple gullible transactions in the garb of ‘ordinary course of business’ and often the question as to whether or not a transaction is preferential/ fraudulent has to be determined by the adjudicating authorities on the basis of facts. In the instant case, the SC upheld the ruling of NCLAT which has heavily relied on Anuj Jain case and the principles enunciated by the SC therein. However, it may be noted from a reading of the order and limited facts there, it appears that the facts of the instant case are different from the precedent applied. Further, the interpretation of ‘ordinary course” may be subject to further discussion as there are more judicial precedents. However, the ruling reinforces the principles enunciated in Anuj Jain case.

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^[1] 2020 SCC OnLine DL 1479

^[2] Company Appeal (AT) (Insolvency) No. 396 of 2022, 405 of 2022 and 412 of 2022

^[3] Our write up on the same can be accessed at: https://indiacorplaw.in/2018/05/jaypee-infratech-case-discerning-reach-avoidance-proceedings.html

See also our write up on Security Interests as Preferential Transactions here:

http://vinodkothari.com/2018/05/security-interests-as-preferential-transactions/

^[4] Civil appeal no. 4125 of 2023

^[5] Law relating to Insolvency and Bankruptcy Code, 2016: Vinod Kothari and Sikha Bansal: Taxmann

^[6] Law relating to Insolvency and Bankruptcy Code, 2016: Vinod Kothari and Sikha Bansal: Taxmann

^[7] Law relating to Insolvency and Bankruptcy Code, 2016: Vinod Kothari and Sikha Bansal: Taxmann

^[8] Law relating to Insolvency and Bankruptcy Code, 2016: Vinod Kothari and Sikha Bansal: Taxmann

^[9] (1948) 76 CLR 463

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Our Resources on the topic can be accessed here:

1. Security Interests as Preferential Transactions
2. Discerning the Reach of Avoidance Proceedings
3. Look- Back Period Vis-À-Vis Fraudulent Transactions
4. A Note on Fraudulent Trading and Wrongful Trading