Anuj Jain, IRP for Jaypee Infratech vs Axis Bank: Clearing the Air Qua Preferential Transactions and Third-Party Mortgages under IBC

The Supreme Court in its recent judgment in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited Etc. [Judgment dated 26.02.2020 in Civil Appeal No. 8512-8527 OF 2019] has clarified several issues including the scope and ambit for adjudication of preferential transactions, and the nature of financial debt particularly in relation to third-party mortgages amongst others. The present article seeks to encapsulate the crux of the judgment in a brief manner. The major highlights of the judgment are as follows:.I. Ambit and Scope of Preferential TransactionsIn the instant case, the Supreme Court was called upon to decide whether several mortgages of parcels of land made by the corporate debtor/Jaypee Infratech Limited (JIL) to raise funds/serve as collateral security for the debt of the parent company/Jaiprakash Associates Limited (JAL) of the corporate debtor would fall within the category of preferential transactions. .Dealing with the rival submissions raised by the parties, the Supreme Court elucidated the principles governing the adjudication and determination of preferential transactions under the Insolvency and Bankruptcy Code, 2016 (Code)..Strict Construction of Section 43 The Supreme Court agreed with the contention of the respondents that the provisions of Section 43 of the Code relating to preferential transactions need to be strictly construed as the consequences of declaring a transaction a preferential transaction are serious. However, it was further held that any such construction taken has to be such that it leads towards achieving the object of the provision..Elements of Preferential Transaction .The Supreme Court clarified that for a transaction to fall under the heading of a preferential transaction, in terms of the Code, three conditions are required to be fulfilled i.e. the transaction of transfer of property or an interest thereof of the corporate debtor, ought to be for the benefit, which may be direct or indirect, of a creditor or a surety or a guarantor for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor; and further such transfer ought to be of the effect of putting such creditor or surety or guarantor in beneficial position than it would have been in the event of distribution of assets under Section 53 (which provision provides for how the proceeds from the sale of assets of the corporate debtor under liquidation are to be distributed amongst the creditors) and finally, such event, of giving preference, ought to have happened within and during the relevant time. It was held that the relevant time as per sub-section (4) of Section 43 of the Code, is a period of two years preceding the insolvency commencement date if the preference is given to a related party (other than an employee) and if the preference is given to an unrelated party, then the relevant time is a period of one year preceding such commencement date..In light of the fact that JIL was a subsidiary of JAL and JIL owed several debts towards JAL, the Supreme Court held that JAL is a related party to JIL and is also a creditor as well as surety of JIL. The Supreme Court further held that JIL had given a preference by way of the mortgage transactions in question for the benefit of JAL for and on account of debts owed to JAL. It also noted that JAL as an operational creditor stood on a much lower footing in the priority of recovery of debts in terms of Section 53 of the Code and thereby, by the mortgage transactions, JAL was put in a much more beneficial position vis-à-vis other creditors than it would have been in the absence of such transfers..Relevant Time and Retrospective Effect The Supreme Court held that the transaction with JAL was a transaction with a related party and therefore, the relevant time would amount to two years prior to the insolvency commencement date. The respondents urged that the provisions of Section 43 of the Code, would have to come into operation at least one year after the enactment of the Code as in the alternative, it would amount to giving retrospective effect to these provisions which is not permissible. The Supreme Court rejected the submissions of the respondents and held that after coming into force of the provisions, if a look-back period is provided for the purpose of any particular enquiry, it cannot be said that the operation of the provision itself would remain in hibernation until such look-back period from the date of commencement of the provision comes to an end. Thereby, the Supreme Court held that the relevant time would be two years prior to insolvency commencement date and there would be no delay in the coming into operation of Section 43 of the Code and that, the mortgage transactions were within the relevant time..Section 43: Deeming FictionThe Supreme Court held that Section 43 was in the nature of a deeming fiction and wherever, the three elements as described aforesaid would exist, then such transaction entered into by a corporate debtor would be regarded as preferential transaction with the attendant consequences, irrespective whether the transaction was in fact intended or even anticipated to be so..Effect of Re-MortgageThe respondent banks had argued that the lands had been mortgaged prior to the relevant time and had only been re-mortgaged during the relevant time. The Supreme Court held that once a property is released and fresh mortgage is done within the two years from the insolvency commencement date, then the transaction would be within the relevant time..Exceptions to Preferential Transactions The Supreme Court took note of Section 43(3) of the Code which provides that even if a transaction has all the elements of a preferential transaction, it would be excluded from being considered as such if the transfer was made in the ordinary course of business or financial affairs of the corporate debtor or transferee or the transfer was a transfer creating security interest in a property acquired by the corporate debtor to the extent that such security interest secures new value and was given at the relevant time and was registered with an information utility on or before thirty days after the corporate debtor received possession of the property..The respondents urged that the mortgage transactions were made in the ordinary course of business of the transferee banks and thereby would not fall under the category of preferential transactions. The Supreme Court rejected the aforesaid submission and held that such an interpretation would amount to frustrating the provision as in such a scenario, almost every transfer made to the transferees like the lender-banks/financial institutions would be taken out of the umbrella of preferential transactions. Thereby, the Supreme Court read the expression “or”, appearing as disjunctive between the expressions “corporate debtor” and “transferee”, in Section 43(3)(a) to mean “and”; so as to be conjunctive of the two expressions i.e. both the corporate debtor and the transferee must have made the transfer in the ordinary course of their business or financial affairs..The Supreme Court quoted the decision of the High Court of Australia in Downs Distributing Co Pty Ltd v. Associated Blue Star Stores Pty Ltd (in liq) [1] which defined business as an ordinary course to mean 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 Supreme Court held that the ordinary course of business or financial affairs of JIL cannot be taken to be that of providing mortgages to secure the loans and facilities obtained by its holding company and that too at the cost of its own financial health. Therefore, these transactions were held to be preferential and security interests created by the JIL over the properties in question were discharged in whole..Due Diligence by BanksThe bankers raised a contention that if the aforesaid interpretation was to be taken then it would impact a large number of banking transactions and would adversely affect the economy. The Supreme Court rejected the aforesaid contention and held that it was the duty of the banks to conduct due diligence to ensure that the third party whose security is being taken, is not already indebted or in red and is not likely to fail in dealing with its own indebtedness and that that such third party security is a prudent and viable one and is not likely to be hit by any law. The Supreme Court also noted that the banks could not plead ignorance about the actual state of affairs and financial position of JIL as they were direct creditors of JIL too, to the extent of the advances made to JIL..Undervalued and Fraudulent TransactionsThe Supreme Court clarified that since the transactions with regard to mortgages had been held to be preferential transactions and thereby, it did not need to examine the aspect of whether such transactions were fraudulent or undervalued. However, it observed that arena and scope of the requisite enquiries for undervalued, fraudulent and preferential transactions were different and any resolution professional should move an appropriate application keeping in mind the same. It was also stated that it would have been appropriate for the National Company Law Tribunal to deal with all these aspects separately and distinctively instead of recording combined findings to the effect that the impugned transactions were preferential, undervalued and fraudulent..II. Third-Party Mortgage: Not a Financial Debt The Supreme Court after perusing the definition of financial debt and the relevant judgments in this regard, clarified that for a debt to become financial debt, the basic element required is that it ought to be a disbursal against the consideration for time value of money. It was further held that the requirement of existence of a debt, which is disbursed against the consideration for the time value of money, remains an essential part even in respect of any of the transactions/dealings stated in sub-clauses (a) to (i) of Section 5(8), even if it is not necessarily stated therein. It was also stated that no transaction could stand alone to become a financial debt without the aforesaid key element..Going further, the Supreme Court held that in light of the aforesaid findings, it was clear that a third party to whom the corporate debtor does not owe a financial debt cannot become its financial creditor for the purpose of the Code..The Supreme Court with regard to secured creditors also held that a person having only security interest over the assets of corporate debtor (like the instant third-party securities), even if falling within the description of secured creditor by virtue of collateral security extended by the corporate debtor, would nevertheless not be a financial creditor without there being a disbursal against the consideration for time value of money. It was held that every secured creditor would be a creditor; and every financial creditor would also be a creditor but every secured creditor may not be a financial creditor. In light of the aforesaid, the Supreme Court went on to conclude that the lenders of JAL, on the strength of the mortgages in question, may fall in the category of secured creditors, but such mortgages being neither towards any loan, facility or advance to the corporate debtor nor towards protecting any facility or security of the corporate debtor, it cannot be said that the corporate debtor owes them any financial debt and that, such lenders of JAL do not fall in the category of financial creditors of JIL.. Swaroop George is an advocate practicing at New Delhi..[1] (1948) 76 CLR 463Read Judgment