The Indian market has witnessed a surge in the number of distressed companies being dragged into insolvency. This is on account of past debts or other liabilities owed by the distressed company to its creditors, sureties and/or guarantors (Creditors). The Insolvency and Bankruptcy Code, 2016 (Code) provides the statutory regime for dealing with such insolvent businesses. While dealing with the entire process of insolvency, it also regulates certain types of transactions which could undermine the value of the assets available to Creditors. These transactions are known as ‘avoidable transactions’ i.e., preferential transactions, undervalued transactions, transactions defrauding creditors and extortionate credit transactions. In this article, we will be dealing specifically with ‘Preferential Transactions’.
Sometimes, when a distressed company foresees an insolvency proceeding against it, it begins to look for opportunities to transfer its assets to other group companies or certain Creditors to the exclusion of other Creditors. Such actions by a distressed company jeopardizes the interests of its Creditors. If distressed companies participate in such avoidable transaction(s) after being admitted for insolvency, the National Company Law Tribunal (NCLT) has the power to undo such avoidable transaction(s) to protect the interests of Creditors.
As the name itself suggests, a preferential transaction in simple terms means those transactions where one person is given preference over another. In the context of the Code, a transaction is considered preferential in nature when a distressed company enters into a transaction to transfer its property in favour of one or more Creditor(s), to the exclusion of the others. The Code also deals with certain other nuances in this regard which are to be borne in mind.
The preliminary determination of whether a transaction is a preferential transaction is made by a resolution professional. After the initial determination, the resolution professional may prefer an application to the NCLT for seeking orders against such preferential transactions. However, any order of reversal of such transactions has to be made prior to the approval of the resolution plan by the NCLT.
Transactions are considered preferential transactions ONLY when such transactions are carried out during the ‘relevant period’. Relevant period is of significance to determine whether a transaction would be categorised as preferential or not. If a transaction giving preference to a particular Creditor, to the exclusion of the others, has not occurred within the prescribed look back period then such transaction will not be treated as a ‘preferential transaction’. Hence, to determine a preferential transaction, the resolution professional must first assess whether such transaction had occurred within the prescribed look-back period.
For instance –
In case of a related party, as defined under the Code itself, the look back period is 2 (two) years immediately preceding the admission of the corporate debtor into insolvency. If the corporate debtor is admitted for insolvency on April 01, 2022; the look back period would be the period between April 02, 2020 to April 01, 2022(date of commencement of corporate insolvency resolution process of corporate debtor). Therefore, any transaction entered into by the corporate debtor with a particular Creditor being a related party, prior to this time period will not be treated as preferential.
In any other case, the look back period is 1 (one) year immediately preceding the admission of the corporate debtor into insolvency. Using the same example, the look back period in this case would be between April 02, 2021 to April 01, 2022(date of commencement of corporate insolvency resolution process of corporate debtor). Similarly, any transaction entered into by the corporate debtor with a particular Creditor, prior to this time period will not be treated as preferential.
In addition to the look-back period provisions, there are certain other carve outs (discussed below) which would bring transactions outside the ambit of being classified as preferential in nature.
The Code is heavily regulated with several timelines in play. There are timelines prescribed within which the matter should be decided; the committee of creditors should be formed; the resolution plan should be submitted; etc. However, at times, the backlog of cases in the NCLT does not allow it to comply with these statutory timelines. To make things worse, the pandemic outbreak has made it even more difficult for courts to operate efficiently.
As on date, several companies may have gotten away with transactions that are preferential in nature, severely prejudicing the interests of the Creditors. While the Code has tried to regulate these transactions by incorporating provisions and criteria such as the look back period, they only make it difficult and not impossible for distressed companies to keep assets out of the reach of Creditors.
There are always structures and strategies which can be devised to legitimately carry out transactions which would not fall within the scope of a preferential transaction. Not all restructurings are malafide. Any genuine and legitimate kind of restructuring could be given effect to in compliance with applicable laws.
However, for that, the distressed companies would need to be vigilant. A distressed company would need to be aware or build mechanisms to anticipate future insolvency proceedings that are likely to be initiated against the company. In such cases, the management should immediately act by analysing the situation, anticipating the dispute, and accordingly use legitimate ways to restructure the distressed company.
For instance, there is a noteworthy carve out for the look back period for transactions with non-related parties and for related parties. Transactions which are carried out on an arm’s length basis or for a valid consideration, would not come within the ambit of a preferential transaction even if these transactions took place within the respective look-back periods. Hence, distressed companies could possibly use this to their advantage and structure transactions in such a manner, so that they stay within the ambit of the Code by using legitimate means.
For some of the reasons mentioned above, monitoring and preventing ‘preferential transactions’ could prove to be a cumbersome task. Given that it is the resolution professional’s role to identify and report such transactions, they should be diligent in conducting forensic audits to identify such transactions at the earliest. Companies should be mindful of indulging in acts which are in violation of the Code since that could expose them to certain criminal consequences.
Authors: Anshu Bhanot, Of Counsel and Priyanka Zaveri, Senior Associate | Veyrah Law
The authors can be reached at email@example.com and firstname.lastname@example.org, respectively.Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.