Avoiding preferential and undervalued transactions in insolvency: The issues that the IBC still does not address

Several provisions of the Insolvency and Bankruptcy Code, 2016 (IBC) have left and continue to leave much to be desired, including provisions relating to avoiding preferential and undervalued transactions.

On account of multiple issues in such provisions, several companies, and more particularly, builders, have virtually gotten away with transactions that are patently and ex facie preferential or undervalued transactions with the intention to somehow defeat creditors. As a consequence, these unscrupulous companies have been successful in keeping monies away from the reach of creditors.

Though the IBC has seen several amendments since December 2016, none of them seem to understand ground realities or the manner in which companies are seeking to defeat creditors and the extent they are willing to go to perpetuate this fraud. The author attempts to set out some issues that need urgent attention and suitable changes.

What is a preferential and undervalued transaction?

A transaction is said to be preferential if

(a) it is not done in ordinary course of business and

(b) there is a transfer of property or a transfer of interest of the debtor for the benefit of a creditor or a guarantor on account of a debt owed by the said debtor or if the creditor, with whom the transaction has been entered into, has been put in a beneficial position.

Naturally, each of the above have to be carried out by the creditor or guarantor or surety with an element of bad faith.

Similarly, simply put, a transaction is undervalued if the corporate debtor enters into a transaction which involves the transfer of one or more assets by the corporate debtor for a consideration the value of which is “significantly less” than the value of the consideration provided by the corporate debtor.

In each case, an application can be filed for revisiting and consequently setting aside the transaction,provided such a transaction has been effected within the last 2 years from the order of admission, if it is a related party, and within the last 1 year from the order of admission, if it is a third party.

The problem with the above provisions and the solution

The first issue relates to the “look back period”. This is a period within which the Interim Resolution Professional (IRP/RP) can revisit concluded transactions as being preferential or undervalued. At present, each of the timelines are linked to the date of the order of admission when the National Company Law Tribunal (NCLT) declares that a company has gone into corporate insolvency resolution process (CIRP) rather than to the date when the operational and financial creditor filed their petition.

Obviously, when this provision was introduced ,it was thought that since petitions by operational and financial creditors would be admitted/adjudicated within a 14-day period, a period of 1 year or 2 years from the date of admission of the petition, as the case maybe, is reasonable. It, however, turned out that the courts termed this 14-day period as being directory.

As a consequence of this, petitions filed by operational creditors and financial creditors are being adjudicated by the NCLT within a period of 6 months to a year and a half (in some jurisdictions). Thus, practically, as it stands now, the look back period essentially starts, in some cases, from the date of filing the petition, sometimes even a little after the filing of the petition, and sometimes only a little before the filing of the petition.

When, therefore, the look back period begins (from the date of admission, i.e. a period of 1 year from the date of the CIRP in cases of a third party_, the entire exercise of the RP is an exercise in futility, because preferential and undervalued transactions would have been effected prior to the look back period.

The above is set out in a simple illustration. The corporate debtor, apprehending litigation and owing to the health of the company, carries out an undervalued or preferential transaction with a third party in December 2018 worth approximately Rs. 10 crore. A petition comes to be filed by the financial creditor or the operational creditor in May 2019, which ultimately is allowed in February 2020. Since the look back period starts from February 2020, it goes back one year i.e. till February 2019. As the illegal transaction was effected in December 2018, the transaction cannot be impugned, even though it is illegal on the face of it.

As opposed to that, had the look back period related back to the date of the operational creditor or financial creditor filing the petition, when they were pushed to avail their respective remedies, the preferential and undervalued transaction would have come within the net of the look back period. Consequently, the creditors would have got the benefit of Rs. 10 crore.

In this backdrop, the entire point of incorporating these provisions is lost, especially if the look back period starts from the date of admission of the corporate debtor to CIRP.

That apart, there is absolutely no logic or rationale to have two different timelines for related parties and third parties. It is, therefore, necessary to increase the time frames of the look back period to make it a period of 3 years (akin to a period provided in the Limitation Act, 1963), irrespective of whether the transaction was effected with a related party or a third party.

Additionally, in case of preferential transactions, while the power to set aside preferential transactions have been given only to the RP, in the case of an undervalued transaction, the power to file an application has been provided to the creditor as well as the RP. It is the author's understanding that this has led to multiple problems, including giving the RP a wide discretion in the case of impugning preferential transactions. It has been found that certain RPs, for various reasons, impugn only some transactions and do not impugn others, which in some cases have been ex facie preferential even though it is the RP’s duty to do so under the IBC.

It would be imperative, therefore, to give the power to impugn preferential and undervalued transactions to a creditor, whether such a creditor was part of the Committee of Creditors (CoC) or not, and the RP simultaneously. Thus, if the RP does not impugn a particular preferential transaction, the creditor could do this.

Further, the RPs also have far too much discretion during the CIRP, including whether or not to carry out forensic audit. This discretion provided to the RP ought to be taken away. On the basis of the claim received by the RP from the creditors (after the public notice) and the value of the debt, the IBC should provide for a minimum threshold above which the RP has to mandatorily carry out a forensic audit. The findings of the forensic audit should, thus, be a subject matter of review before the CoC and the NCLT should also be provided the power to initiate suo motu action, if the need so arises.

Besides this, the IBC should also provide for a situation where the corporate debtor has either undertaken a preferential transaction or undervalued the asset and/or transferred the asset to a third party/related party and the third party/related party has further sold the asset to a bonafide purchaser, who has paid valuable consideration for the purchase and also have invested their entire life savings. This is seen more particularly in cases relating to builders.

At present, the situation is that if the NCLT declares the transaction between the corporate debtor and the third party/related party as null and void, the bonafide purchaser is left in the lurch, despite having paid valuable consideration. Such a situation ought to be avoided and the rights of a bonafide purchaser, who has been caught in the elaborate web of a deceitful corporate debtor, ought to be protected.

Conclusion

The issues highlighted above are only a few issues in the IBC. There are a host of other issues, which are being faced by operational creditors, financial creditors, RPs and the CoC. These issues ought to be considered and reviewed by a committee and the IBC ought to be amended to fill the lacunae in the provisions rather than having stop-gap amendments to temporarily fix issues. A comprehensive amendment of the IBC is the need of the hour.