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Avoidance Of Land Contracts Under Insolvency And Bankruptcy Laws

A company is an artificial person running for the fulfilment of a purpose, but at times there are situations that could lead to its downfall and when a company winds up it is potentially taking away employment of everyone associated with it and is also impacting the economy of the country in a negative way.

Therefore, every possible step is taken to avoid this from happening but when it could not be avoided and insolvency proceedings of a company are about to commence, the transactions made and the contracts entered into by the company prior to the commencement of such insolvency proceedings are judged and the ones that are found to be harmful for the company and people associated with it or are violative of the interests of the debtor or the creditor are declared to be void. The process is known as avoidance of pre bankruptcy proceedings.

The insolvency and bankruptcy laws have figured out a way of balancing the rights of both debtor as well as the creditor. Creditors of the entity having a right to claim the dues from the estate of the debtor can not manipulate the debtor into selling off the assets like land, shares and other assets or entering into a contract that is not favouring the interests of the debtor and is anyhow violative of his rights or interests. The transactions made and contracts entered into in this regard are avoidable and prevented to protect the interests of the debtors and are thus known as avoidable transactions.

The aim of avoidable transactions remains to be protective of debtors' assets and maximisation of value of such assets and the availability of credit in lieu of such assets. Ultimately making the financial position of the company better and making the resolution process easier leading to a fair distribution of the assets.

The contracts that are entered into between the two parties prior to the commencement of the insolvency proceedings could be of simple assets, like shares, building, land or it could be a complicated one like those of a franchise, or taking over constructions, etc. Land being a prominent and one of the most valuable assets for any business would be at target of any creditor who has made their aim to cover off their debts from the debtor and overlook other creditors. Therefore, among the other contracts, land contracts that are entered into between the creditor and the debtor are to be avoided.

The UNCITRAL model under part 2 of its legislative guide provides for the avoidance of certain transactions on the part of debtor so as to ensure the equal treatment of all the creditors and protection of the rights of the debtors so as to not get manipulated by any of the creditors to enter into a contract for the transfer of any of the assets at a value lower than that of its actual value.

Another perspective to the same is avoiding favouritism on the part of the debtor, the debtor might prefer a creditor over the others and might enter into a contract with him regarding the transfer of an asset as soon as they become aware of the upcoming insolvency proceedings.

Hence, these transactions that are entered into prior to the commencement of the insolvency proceedings are cancelled or are deemed to be ineffective to ensure the protection of rights of every involved party. Different jurisdictions have based their insolvency laws on the UNCITRAL model however there are distinctions that could be found between the laws of different countries.

The Insolvency and Bankruptcy code, 2016 deals with the avoidable, also known as vulnerable transactions under sections 43 to 51.

The types of transactions that are avoidable under the IBC are:
  1. Preferential transactions
  2. Undervalued transactions
  3. Extortionate credit transaction
The aforesaid transactions are to be avoided by the debtor during the relevant period which is two years in case of a related party and one year in other circumstances preceding the insolvency commencement date as per section 46 of the IBC, 2016.

Uncitral Model and Avoidance Proceedings
The UNCITRAL Model Law is designed to assist States to equip their insolvency laws with a modern legal framework to more effectively address cross-border insolvency proceedings concerning debtors experiencing severe financial distress or insolvency.[1] The legislative guide is consistent of 4 parts on insolvency law covering the objectives, structural issues, mechanism available for the resolution of the debtor's financial difficulties, the commencement, dissolution of the insolvency proceedings, avoidance of proceedings, cross border insolvency laws, other like provisions that require attention in detail.

The legislative guide part 2 provides for the rights of a debtor, wherein it is stated that where the debtor is a natural person, certain assets are generally excluded from the insolvency estate in order to enable the debtor to preserve its personal rights and those of its family and it is desirable that the right to retain those excluded assets be made clear in the insolvency law.[2]

The same part of the legislative guide also provides for avoidance proceedings, which is covered under recommendations 87-99. The avoidance proceedings are based on a general principle of insolvency law that instead of providing individual remedies to the creditors who could claim the assets by entering into a contract with the debtor prior to the commencement of the insolvency proceedings, the priority is given to the collective goal and overall maximisation of the value of the assets and credit availability so as to facilitate equal treatment to all the creditors and the rights of the debtor.

The statement regarding this provided under the guide is, "Provisions dealing with avoidance powers are designed to support these collective goals, ensuring that creditors receive a fair allocation of an insolvent debtor's assets consistent with established priorities and preserving the integrity of the insolvency estate."[3]

Further, the UNCITRAL model also provides for certain avoidance criterias. There are criterias namely, objective, subjective and the combination of the two, ordinary course of business and defences. The state might opt for any of the criterias provided the ultimate aim remains the same, to create a balance between the interests of the individual with the estate.

Criteria:
  1. Objective Criteria:
    The focus is on the objective questions such as whether the transaction took place within the suspect period and whether the transaction evidenced any of a number of general characteristics set forth in the law.[4]
     
  2. Subjective Criteria:
    Subjective approach is more case specific, the questions that would arise would be like whether the intention to hide the assets from the creditors was there, and at what point did the debtor become insolvent whether it was at the time of the transaction or whether it was after the transaction.[5]
     
  3. Combination of the two:
    The insolvency laws of majority of the states is more subjective centric, however it is combined with a time period within which the transaction must have occurred. In India, for example, the relevant period is 2 years in case of a related party and 1 year in case of any other creditor.
     
  4. Ordinary Course of Business:
    A distinction is drawn between what may be considered as a routine or ordinary transaction in a business and what is extraordinary and should be avoided as a part of avoidable transaction. Prior conduct of the debtor could play a role here along with customs and regular practices as followed in the business.
The states are free to take either of the criteria as a base to provide for the avoidable transactions as mentioned aforesaid.

Avoidance actions around the world
As stated above, the UNCITRAL model is merely providing a guide to the states to formulate proper avoidance actions, different jurisdictions follow different set of avoiding power, upon classifying them broadly we can arrive at a conclusion that there are single set and double set of avoiding powers, civil law countries such as France and spain are followers of single set of avoiding powers, whereas common law countries follow double set of avoiding powers, countries such as UK and USA, the double set of avoiding powers are undervalued transactions and unlawful preferences.

American Viewpoint
Claw back actions or avoiding powers is a tool to declare perfectly valid transactions invalid on the ground that they were entered into prior to the commencement of insolvency proceedings. The general reasoning behind invalidation of such a transaction is that the creditors who would be receiving the assets of the firm but would not have any control over them once the formal proceedings commence would make an attempt to take control of the same before the initiation by way of manipulation or any other immoral means.

As mentioned above, the transactions made prior to the insolvency proceedings are harmful to the value of the assets of the firm and at the same time are violative of the rights of the debtor as well as other creditors of the firm. The American insolvency law is primarily focused upon yielding the maximum benefit for the creditor.

Automatic stay
Automatic stay is a key principle of the U.S. insolvency regime . Section 362 of the bankruptcy code deals with the provisions of automatic stay, this becomes applicable once the insolvency proceedings commence. The stay would prevent any creditor from recovering any asset or property from the debtor. This procedure helps the creditors by enjoying their remedies to recover . However the automatic stay is not absolute, it has some exceptions and it can be amended by court by depicting a reasonable cause. Automatic stay is a safeguards for creditors as it saves debtors property from value degradation and ensures its proper distribution .

The Absolute Priority Rule
The Absolute priority Rule is also a key principle in the US insolvency regime . this rule is based on fair and equity as this rule directs that creditors who have investments must be paid in priority than other creditors who have small investments which means that secured creditors will be paid before the unsecured creditors and at last the equity holders because they have lowest priority however this rule can be bypassed by voting of senior members , payment of junior class or unsecured creditor can be possible if votes of senior members are obtained .

Avoidance Actions
In the US the bankruptcy law points out various procedures that permit the debtors to bypass the pre bankruptcy transfer of the resources . This gives debtors the right to increase the value of his bankruptcy estate and stop value degradation of estate before the bankruptcy suit as it may create bias in creditors .

Australian viewpoint
The transfer of property in the Australian law at the time of bankruptcy is dealt by the provisions mentioned under the bankruptcy act, 1924-1946. Section 95[6] of the act deals with it and provides that Every transfer of property, every payment made, every obligation incurred by any person unable to pay his debts as they become due from his own money, in favour of any creditor or of any person in trust for any creditor, having the effect of giving to that creditor, a preference, a priority or an advantage over the other creditors, shall, if the debtor becomes bankrupt on a bankruptcy petition presented within six months thereafter be void as against the trustee in bankruptcy. In the case of Downs distributing Co. Pty. Ltd. V. Associated Blue Star Stores Pty. Ltd[7] This provision of the bankruptcy act played a role in the ultimate decision given by the court.

Indian viewpoint
The insolvency and bankruptcy code is a relatively new law and is influenced by the common law countries when it comes to the avoidance powers. Sections 43- 51 deal with the avoidance proceedings wherein contracts of transfer of assets or property could be the subject of avoidance proceedings.

Avoidance of transactions and declaration of contracts entered into by the parties as null and void could be of any contract, regarding the transfer of any property or asset. Land contract is no exception, the case of Jaypee Infratech Limited Vs. Axis Bank Limited is the perfect example of avoidance of a transaction that is based on transfer of an immovable property.

In the instant case, Jaiprakash Associates Limited (JIL), which is the holding company of Jaypee infratech limited set up the aforesaid subsidiary as a special purpose vehicle for the construction of an expressway and entered into an agreement with the Yamuna Expressway Industrial Development Authority. For this purpose, loans were taken from various banks collectively, mortgaging the land and 51% shareholding of JIL.

Later on, JIL was declared to be a non performing asset by some of its lenders and NCLT passed an order under section 7 of the IBC, 2016 to initiate the insolvency proceedings after the petition was filed by IDBI bank regarding the same. The appointed IRP filed an application regarding the transactions entered into by the corporate debtor that have created a liability on the immovable property owned by the corporate debtor and in that application such transactions were claimed to be preferential, undervalued, and fraudulent.

The application was addressed and allowed. An appeal was filed by the creditors to set aside the NCLT orders.

The issues therefore, faced by the supreme court were as follows:
  1. Whether the transactions entered into by the debtor are undervalued, preferential and fraudulent?
  2. Whether the respondents were financial creditors given the fact that the property was mortgaged to them?
The NCLT observed that the land was mortgaged in order to defraud the lenders. At the time of entering the transactions, the debtor was already facing a financial crunch and the creditors were aware of the debtor's position at the time of entering into the mortgage contract. Therefore, the adjudicating authority was of the view that the debtor was trying to make a fraudulent transaction during the twilight period and the sole objective of the debtor was to generate some cash, thus not falling within the category of ordinary course of business.

The appellate authority on the other hand, held that section 43(2) was not attracted and the mortgage was made in ordinary course of business. Also the transactions were not undervalued or preferential and the adjudicating authority has no power to make orders regarding the same.

As far as the preference is concerned, the apex court held that the debtors have entered into a preferential transaction. The supreme court upheld the decision of NCLT and held that section 43[8] hit the present case. The three fold test is required to be passed by a translation in order to become a preferential transaction under this section, i.e,. Fulfilling the requirements of Section 43(4) and 43(2), and should not fall under the exceptions mentioned in Section 43(3).

Sub section 2[9] section 43 talks about the transactions in which the corporate debtor shall be deemed to have been given a preference. The provision clearly talks about transfer of property or interest in that property by the corporate debtor in order to benefit a creditor for an account of financial or operational debt. The section aims to invalidate the transactions wherein preference was given by a corporate debtor and involves the instances of transfer of property. Thus covering land related contracts within its ambit.

The provision of section 43 was attracted in this case; however, a different approach was taken up in the case of The Goodwill Theaters vs Suntech Realty, in this case the question arose whether the developer who was granted development rights by the landowner be classified as an operational creditor and it was held that transfer of development rights did not amount to supply of goods or services, therefore the developer would not be classified as an operational creditor.

The above mentioned transactions as stated in sub section 3 would not be considered as a part of preferential transactions in case the transfer is made in ordinary course of business and is creating a security interest in the property.[10]

Another type of transaction that can be avoided is provided under section 45[11] of the code is the undervalued transaction. In the aforesaid case of Jaypee infratech, the IRP was of the view that the transactions are not just preferential but also undervalued, it was ultimately held that the transaction was in fact undervalued. An undervalued transaction is one in which the corporate debtor has paid an amount lesser than the actual value of the asset.

The mentioned case is also an example of transactions that could be avoided on the ground that they are defrauding the creditors. Section 49[12] of IBC deals with the provision of defrauding the creditor. In case the corporate debtor has made an undervalued transaction intentionally, this provision would be attracted.

Lastly, the IBC provides for another type of avoidable transactions, that is extortionate credit transaction. Section 50[13] talks about the extortionate transactions. Any transaction that is unfavourable to the corporate debtor and is made at the time when the debtor was vulnerable is considered as an extortionate transaction. There can be situations like the contract was either signed by the debtor without reading or it was deliberately made to favour the creditor as the debtor would sign the contract being vulnerable at the time.

Conclusion
We have established that certain transactions are avoidable and hence declared void if the question of interest of either the debtor or any other creditor the firm is involved. The jurisdictions across the world have settled on different viewpoints regarding the laws governing such proceedings. However, the transactions and contracts entered into are to be judged very carefully.

The possibility of them being made as an ordinary course of business exists. Land contracts especially, land being one of the most valuable assets of any business could become an easy target by the creditors who wish to cause harm to the debtor by taking it away at a lower price at the same time the debtor also could enter into a transaction involving land with an ill will. Therefore, the avoidance proceedings are to be carefully examined and then avoided to preserve the interests of all the involved parties.

End-Notes:
  1. UNCITRAL Model Law on Cross-Border Insolvency available at https://uncitral.un.org/en/texts/insolvency/modellaw/cross-border_insolvency
  2. UNCITRAL legislative guide on insolvency law part 2 https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf page 167 point 20
  3. https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf page 136 point 151
  4. https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf page 137 point 157
  5. https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf page 138 point 158
  6. (1) Every conveyance or transfer of property, or charge thereon made, every payment made, every obligation incurred and every judicial proceeding taken or suffered, by any person unable to pay his debts as they become due from his own money, in favour of any creditor or of any person in trust for any creditor, having the effect of giving that creditor, or any surety or guarantor for the debt due to that creditor, a preference over the other creditors, shall, if the debtor becomes bankrupt on a bankruptcy petition presented within six months thereafter be void as against the trustee in bankruptcy
  7. https://staging.hcourt.gov.au/assets/publications/judgments/1948/012--Downs_Distributing_Co._Pty._Ltd._V._Associated_Blue_Star_Stores_Pty._Ltd._(In_Liquidation)--(1948)_76_CLR_463.html
  8. (1) Where the liquidator or the resolution professional, as the case may be, is of the opinion that the corporate debtor has at a relevant time given a preference in such transactions and in such manner as laid down in sub-section (2) to any persons as referred to in sub-section (4), he shall apply to the Adjudicating Authority for avoidance of preferential transactions and for, one or more of the orders referred to in section 44.
  9. (2) A corporate debtor shall be deemed to have given a preference, if- (a) there is a transfer of property or an interest thereof of the corporate debtor for the benefit 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 (b) the transfer under clause (a) has the effect of putting such creditor or a surety or a guarantor in a beneficial position than it would have been in the event of a distribution of assets being made in accordance with section 53.
  10. (3) For the purposes of sub-section (2), a preference shall not include the following transfers- (a) transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee; (b) any transfer creating a security interest in property acquired by the corporate debtor to the extent that- (i) such security interest secures new value and was given at the time of or after the signing of a security agreement that contains a description of such property as security interest and was used by corporate debtor to acquire such property; and (ii) such transfer was registered with an information utility on or before thirty days after the corporate debtor receives possession of such property: Provided that any transfer made in pursuance of the order of a court shall not, preclude such transfer to be deemed as giving of preference by the corporate debtor.
  11. (1) If the liquidator or the resolution professional, as the case may be, on an examination of the transactions of the corporate debtor referred to in sub-section (2) of section 43 determines that certain transactions were made during the relevant period under section 46, which were undervalued, he shall make an application to the Adjudicating Authority to declare such transactions as void and reverse the effect of such transaction in accordance with this Chapter

    (2)A transaction shall be considered undervalued where the corporate debtor- (a) makes a gift to a person; or (b) enters into a transaction with a person 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, and such transaction has not taken place in the ordinary course of business of the corporate debtor.
  12. Where the corporate debtor has entered into an undervalued transaction as referred to in sub-section (2) of section 45 and the Adjudicating Authority is satisfied that such transaction was deliberately entered into by such corporate debtor: (a) for keeping assets of the corporate debtor beyond the reach of any person who is entitled to make a claim against the corporate debtor; or (b) in order to adversely affect the interests of such a person in relation to the claim, the Adjudicating Authority shall make an order: (i) restoring the position as it existed before such transaction as if the transaction had not been entered into; and (ii) protecting the interests of persons who are victims of such transactions;
  13. Where the corporate debtor has been a party to an extortionate credit transaction involving the receipt of financial or operational debt during the period within two years preceding the insolvency commencement date, the liquidator or the resolution professional as the case may be, may make an application for avoidance of such transaction to the Adjudicating Authority if the terms of such transaction required exorbitant payments to be made by the corporate debtor.

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