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Preferential Transactions Under IBC: A Much-Needed Course Correction

Preferential transactions under the scheme of Insolvency and Bankruptcy Code (Code) attained much needed clarity after the recent Supreme Court ruling in the case of Anuj Jain v. Axis Bank Ltd. The said appeal was filed by the Interim Resolution Professional (IRP) challenging the order of NCLAT, holding third-party mortgages created by Jaypee Infratech Limited (JIL) in favour of the lenders of Jaiprakash Associates Limited (JAL) as not preferential. In a comprehensive judgmentthe Court discussed the intent and scheme of preferential transactions under the Code and provided clarity with regard to the exception clause of Section 43.

This article is an attempt to analyse preference under the scheme of the Code, in light of the recent judgment and also seeks to address the stance taken by the Court on different aspects of Section 43 and 44 of the Code.

Preference under the Code
Even though preferential transactions have been discussed under Part II Chapter III of the Code, but under Section 25(2)(j), the IRP has a duty to file an application for the avoidance of such transaction in accordance with the provisions given under Chapter III.

Preference under the Code primarily entails, certain form of benefit(s) that are provided by the Corporate Debtor to its creditor/surety/guarantor on account of any antecedent financial, operational or other form of debt, which in turn has the effect of putting such creditor in a beneficial position with respect to other creditors in the event of distribution of assets under the scheme of the Code.

A transfer to be classified as preferential under the Code needs to fall within the look back period mentioned under Section 43. Preference as also discussed under Section 547 of the US Bankruptcy Code and Section 239 of the UK Insolvency Act, provides for situations and look back period in order to classify a transaction/transfer as preferential with respect to the insolvent debtor. Look back period is generally considered to be the time frame for the purpose of avoidance of transactions on account of preference. An order under Section 44 of the Code by the Adjudicating Authority can be passed only when the transaction/transfer is in a manner specified under 43(2) and is to any of the persons specified under 43(4).

As Section 43(2) contains ‘and' conditions, a Corporate Debtor shall be deemed to have given preference only if such transfer of property or interest has been made for the benefit of the creditor and it has the effect of putting such creditor in a better position during the distribution of assets under the Code.

After satisfying the conditions as given under 43(2), the relevant look back period is ascertained to classify whether a transfer can be considered a preferential or not. Under Section 43(4) two different look back periods are enumerated with respect to the nature of beneficiary to whom such transfer is made. As JAL was a related party[i] of the Corporate Debtor under the Code, the look back period was of two years, hence every transfer in nature as specified under 43(2), two years preceding the insolvency commencement date was considered to be preferential.

Deeming Fiction

While discussing the nature of transactions, the Court dwelled into the deeming fiction of preferential transactions as laid down under the Code. Deeming fiction of a provision means to deem what might not exist in reality and treating the subject matter as true. One of the primary objectives of following such an approach is to eliminate the need of intent while construing a provision. Hence, if a transaction satisfies conditions as laid down under clause (2) and (4) of Section 43, it excludes the need of establishing intent as the provision deems that such transaction was meant to be preferential in the first place.

One of the submissions made by the Respondents before the Court was a challenge to the retrospective application of Section 43. While providing clarity on such provision, the Court held that merely because a provision provides for retrospective application, it does not imply that the said provision is retrospective in nature. As no new liability was being imposed or right created with respect to corporate persons, there existed no need to read unnecessary conditions of retrospectivity for challenging the applicability of such provision.

Exceptions
Even if a transfer fulfils the conditions as laid down under clause (2) and (4) of Section 43, it cannot be avoided on the ground of being preferential if it falls under any of the conditions as laid down under clause (3) of Section 43. A transfer made in the ordinary course of business or financial affairs of the Corporate Debtor or the Transferee, or which intends to create a security interest that leads to new value shall be excluded from the application of clause (2).

Ordinary course of business or financial affairs

One of the primary contentions of the Appellants in the said case was with regard to conjunctive reading of or as and appearing in Section 43(3)(a). If a literal interpretation of said clause is undertaken then every form of mortgage given to financial institutions/transferees might get excluded despite the fact that they may be preferential in nature. The purpose of Section 43 of the Code is to secure the wealth of the Corporate Debtor from such transactions that might be prejudicial to the interest of stakeholders.

The Court adopted the principle of Noscitur a sociis and held that in light sub-clause (b) of Clause (3) it can be ascertained that any transaction that leads to value enhancement for the Corporate Debtor cannot be considered as preferential in nature.

The Court held that in light of the scheme of the Code and intent of the legislature while framing Section 43, a purposive interpretation needs to be undertaken and ‘or' appearing in 43(3)(a) should be read as and so as to be conjunctive of Corporate Debtor and Transferee. One of the primary objectives of an investigation under such clause is to look whether such transaction was in ordinary course of business or financial affairs of the Corporate Debtor or not, even though it may be for the transferee.

Ordinary course of business need not be construed in a rigid and pedantic manner and it should not be confined to the primary business of the Corporate Debtor. Ordinary course of business can include all those transactions and transfers that form a part of the undistinguished common flow of business done and do not arise out of any particular or special circumstance.[ii]

Drawing a line between Preferential, Undervalued and Fraudulent Transactions

It is often misconceived that a preferential transaction is generally undervalued and fraudulent in nature. Allahabad bench of NCLT while holding the transactions preferential in nature, also gave an order classifying them as undervalued and fraudulent under Section 45 and 66 of the Code respectively. The Court while drawing a line between such transactions emphasised that merely because a transfer is preferential does not essentially imply that it is undervalued and fraudulent in nature. Different enquiry needs to be undertaken for the purposes of undervalued and fraudulent transfers.

Conclusion
A disjunctive reading of or appearing in 43(3)(a) would lead to exclusion of majority of preferential transfers out of the ambit of the Code. Ordinary course of business or financial affairs of the Corporate Debtor should be the primary focus of enquiry in order to understand the nature of transfer. The yardstick to understand preference under the Code should be the effect of such transfer on the overall financial health of the Corporate Debtor. The Supreme Court while allowing for a purposive interpretation of such provision has remedied the inherent defect in the clause. This judgement forms an important milestone in development of jurisprudence on Insolvency laws, especially in the unchartered territory of preferential transactions.

End-Notes:

  1. As explained under 5(24) of the Insolvency & Bankruptcy Code, 2016.
  2. Downs Distributing Co. Pty Ltd. v. Associated Blue Star Store Pty. Ltd., (1948) 76 CLR 463

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