Supreme Court on Preferential Transactions and Related Parties Under IBC

[By Vatsal Patel]

The author is a fourth year student of Institute of Law, Nirma University.

Introduction

The Insolvency and Bankruptcy Code, 2016 (“IBC”) has been a game-changer in the field of corporate bankruptcy in India. Though, there is still scepticism, looming over the IBC’s economic significance with a lot of companies going into liquidation as opposed to the intended corporate revival,[i] there is no doubt that the IBC has provided for a clear and robust guiding mechanism during the Corporate Insolvency Resolution Process (“CIRP”).[ii]

Recently, the Supreme Court of India in the case of Anuj Jain v. Axis Bank,[iii] commonly referred to as the “Jaypee Case”, further outlined the powers of the Resolution Professional (“RP”) in terms of handling of various claims and transactions submitted by the Committee of Creditors (“CoC”). The Court further clarified the application of different provisions of the IBC which till now had not been suitably expounded. The piece aims to discuss in detail this judgement of the Supreme Court; and explain why the reasoning of the Court is correct and should serve as a guide for all future decisions.

Factual Matrix

Jaypee Infratech Ltd. (“JIL”), the corporate debtor in the present case is undergoing CIRP due to the committal of a default.[iv] Jaiprakash Associates Ltd. (“JAL”) the holding co. of JIL, has approximately 71.64 % equity in JIL.[v] Before the initiation of the CIRP, JIL, the subsidiary company had mortgaged certain parcels of land in favour of the lenders of JAL, the parent company in furtherance of the benefit to the parent company.[vi] This was despite the fact that JIL was itself undergoing a financial crunch, and was unable to pay up its own debts.[vii]

Why was this problematic? The reason it was problematic was because of these transactions, certain creditors of the parent company would be favoured in the distribution of assets as per waterfall mechanism laid down in Section 53 of IBC, wherein their claim would be satisfied before, in the order of priority, as compared to the claims of other claimants who are otherwise similarly placed. The Interim Resolution Professional (“IRP”) i.e. Anuj Jain, bound by Section 25(2)(j) of IBC and armed with the objective of ensuring parity between all the creditors, filed an application seeking to set-aside all these transactions as being violative of Sections 43, 45, 49 and 66 of IBC. While the NCLT ruled in favour of the IRP, the NCLAT reversed this decision in favour of Respondents in the present case,  the primarily lenders of JAL.

Analysis of the judgment

The judgment of the Supreme Court, for the purposes of this piece, is coherently segmented into two parts – firstly, it discusses the contours of Section 43 IBC and its application it to the facts of the present case; and secondly, it distinguishes the application of Section 43 IBC from that of Sections 45, 49 and 66 IBC. The judgment also adjudicates upon the existence of a financial debt in cases wherein a mortgage is created by a corporate debtor in favour of a third party.[viii] However, the same has not been discussed by the author in this blog post.

Contours of Section 43 of IBC

Section 43 IBC is concerned with two things – preferential transaction and relevant time.[ix] To simplify, if the liquidator or RP is of the opinion that at a relevant time, a preference has been given by corporate debtor to a particular creditor in certain transactions, the liquidator or the RP shall be bound to make an application under Section 44 IBC for setting aside such a transaction.[x]

After going through various interpretations of “preference”,[xi] the Court held “preferential transaction” as:

being the transaction where an insolvent debtor makes transfer to or for the benefit of a creditor so that such beneficiary would receive more than what it would have otherwise received through the distribution of bankruptcy estate.[xii]

In relation to “relevant time”, the Court observed that it is normal to have a longer look-back period in case of a related party, and a shorter one in case of an unconnected party.[xiii] The Court further observed that a strict construction should be given to Section 43 but only after giving of apposite consideration to the underlying principles and objectives of IBC.[xiv]

Thereafter, the Court devised a step-by-step process which must be applied by the RP (initially) and Tribunals (upon an application under Section 44 IBC) to see whether a transaction is hit by Section 43. These steps are as follows:

  • Firstly, whether the transfer by way of transaction is for the benefit of the surety or guarantor in furtherance of an antecedent financial liability of corporate debtor [Section 43(2)(a) IBC];
  • Secondly, whether such a transactions puts the surety or guarantor at a beneficial position than in case of a distribution of assets as per Section 53 IBC [Section 43(2)(b) IBC];
  • Thirdly, whether the transaction was made two years prior in the case of a “related party”[xv] or one year otherwise [Section 43(4) IBC]; and
  • Fourthly, whether such transaction is not and “excluded transaction” as per Section 43(3) IBC.[xvi]

In its essence, the Court meant for a transaction to be a “preferential transaction” under IBC if the ingredients of clause 2 and 4 of Section 43 IBC are satisfied, and it is not protected by clause 3 of Section 43 IBC. The Court by formulating this test made it easier for the RPs and Tribunals to adjudicate upon the existence of a “preferential transaction”. Now, they need not interpret Section 43 in a broad manner but are only required to mechanically follow the stipulated steps. This brings in a greater degree of certainty in the CIRP.

However, what is more important is that the Supreme Court applied it aptly to the facts of the present case. The Court began by holding that the non-existence of a creditor-debtor relationship between the lenders and corporate-debtor is not of significance because the ultimate benefit flowed to its parent co. i.e. JAL,[xvii] who is a “related party” to JIL. Furthermore, the Court recognised that in the absence of  creation of a mortgage by JIL, JAL would have to depart with great estate as per Section 53 IBC than it would have now.[xviii] Thus, there was clear satisfaction of Section 43(2) for a look-back period of two years as per Section 43(4)(a) IBC.

The only thing that was now left to be discerned was whether the mortgages were protected by any of the exclusionary terms of Section 43(3) IBC. It was the respondents’ contention that the mortgages were done in the ordinary course of business of the transferee, and that Section 43(3) granted protection to both – corporate debtor and transferee because of the presence of the word “or”. Therefore, they must not be hit by Section 43 IBC.

The Court firmly rejected this interpretation because of two reasons.

Firstly, the Court relied on the definition of “ordinary course of business” in the landmark case of Downs Distributing Co. v. Associated Blue Star Stores,[xix] wherein it was held to mean “a transaction that falls into place as part of the undistinguished common flow business done”. Relying on this, the Court was of the opinion that the mortgages were not in the ordinary course of business of the corporate debtor as lending was not in the ordinary course of business of the corporate debtor.[xx]

Secondly, the Court interpreted the term “corporate debtor or transferee” in Section 43(3) IBC to actually mean “corporate debtor and transferee”. This was because in the Court’s opinion, a lender would always be involved with mortgaging in the ordinary course of its own business. The true purpose of Section 43(2) is not to look into the ordinary course of business of the transferee but that of the corporate debtor.[xxi] This ingenious interpretation of the Court is welcome and has plugged a great loop-hole in interpretation of Section 43 IBC.

Distinction between Section 43 v. Sections 45, 49 and 66

The Court was of the opinion that there was a sharp distinction between the two sets of provisions with Section 43 on one side and Sections 45, 49 and 66 on the other. The Court held Section 43 is a “deeming provision” and therefore, no intent was required in the violation of Section 43. All there has to be is a simple non-fulfilment of the requirements of Section 43. On the other hand, Sections 45, 49 and 66 required an element of intent for their committal.[xxii]

Conclusion

This judgement has been the first ruling by the Supreme Court in terms of laying down the principles of Section 43 of the IBC. The Court performed the task well and formulated the tests in a coherent manner for future Courts to follow. The Court’s distinction between Section 43 and Sections 45, 49 and 66 is also ingenious as this will now reduce confusion for the RP in bringing either a charge of “preferential transaction” or that of a “fraudulent” or “undervalued” transaction, both of which require the satisfaction of distinct ingredients.

End Notes

[i] Prasanna Mohanty, Reality Check: Challenges Notwithstanding, IBC Promises Positive Changes In Bankruptcy Law Of India, Business Today (Dec 11, 2019), https://www.businesstoday.in/current/economy-politics/ibc-insolvency-and-bankruptcy-code-india-promises-positive-changes-credit-default-resolution-professionals-nclt-cases-corporates-liquidation-process/story/391873.html.

[ii] Prateek Jain, Sneha Janakiraman & Smriti Nair, The Essar Steel Saga: Supreme Court Brings Much Needed Clarity To IBC, Mondaq (Nov 28, 2019), https://www.mondaq.com/india/InsolvencyBankruptcyRe-structuring/869318/The-Essar-Steel-Saga-Supreme-Court-Brings-Much-Needed-Clarity-To-IBC.

[iii] Civil Appeal Nos. 8512-8527 (Supreme Court of India).

[iv] Insolvency and Bankruptcy Code, 2016, § 3(12).

[v] supra note iii at ¶ 3.2.

[vi] Id. at ¶ 4.1-4.5.

[vii] Id. at ¶ 14.2.1.

[viii] Id. at ¶ 107.

[ix] Id. at ¶ 16.

[x] Insolvency and Bankruptcy Code, 2016, § 43(1).

[xi] supra note iii at ¶ 17.1.

[xii] Id. at ¶ 17.2.

[xiii] Id.

[xiv] Id. at ¶ 18.

[xv] Insolvency and Bankruptcy Code, 2016, § 5(24).

[xvi] supra note iii at ¶ 20.

[xvii] Id. at ¶ 22.2.1.

[xviii] Id. at ¶ 22.4.

[xix] (1948) 76 CLR 463 (High Court of Australia).

[xx] supra note iii at ¶ 25.6.2.

[xxi] Id.

[xxii] Id at ¶ 29.1.

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