IBC PROJECT PREFERENTIAL TRANSACTIONS

Insolvency and Bankruptcy Code Project:

PREFERENTIAL TRANSACTIONS:
SPECIAL REFERENCE TO IDBI BANK LTD. V.
JAYPEE INFRATECH

Submission By:

Vedantha Sai

Roll No: 1317

7th Semester – ‘B’ Batch

1|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

TABLE OF CONTENTS

I. INTRODUCTION ....................................................................................................................... 3
II. PREFERENTIAL TRANSACTION ............................................................................................. 3
III. SCHEME OF SECTION 43 OF THE CODE ............................................................................ 4
LIQUIDATOR OR RP FORMING AN ‘OPINION ’ [SECTION 43(1)].................................................. 4
MANNER OF PREFERENCE [SECTION 43(2)] ............................................................................... 4
RELEVANT PERIOD AND LOOK-BACK PERIOD [S ECTION 43(4)] ................................................. 4
IV. EXCEPTIONS TO PREFERENTIAL TRANSACTIONS ............................................................ 5
COMPANY LAW PERSPECTIVE .................................................................................................... 5
INSTITUTIONAL INVESTOR ADVISORY SERVICES GUIDELINES ................................................. 5
UNCITRAL FRAMEWORK ......................................................................................................... 6
DICTIONARY DEFINITIONS .......................................................................................................... 6
RATIONALE ................................................................................................................................. 6
UNCITRAL LEGISLATIVE FRAMEWORK ................................................................................... 6
ILLUSTRATIONS ........................................................................................................................... 7
CONDITIONS TO AVAIL THE EXEMPTION .................................................................................... 7
V. ANALYSIS OF IDBI V. J AYPEE INFRATECH ......................................................................... 7
INTRODUCTION ............................................................................................................................ 7
APPLICATION OF SEC. 43 ............................................................................................................ 8
FOUR -POINT TEST FOR PREFERENTIAL TRANSACTIONS ............................................................ 8
ORDINARY COURSE OF BUSINESS ............................................................................................... 8
CONTRADICTORY NATURE ......................................................................................................... 9
VI. SUGGESTION ....................................................................................................................... 9
VII. CONCLUSION ....................................................................................................................... 9
VIII. REFERENCES ..................................................................................................................... 10
LEGISLATION AND RULES ......................................................................................................... 10
ONLINE SOURCES ...................................................................................................................... 10
LEGAL DATABASES ................................................................................................................... 10
CASE LAW ................................................................................................................................. 10

2|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

I. INTRODUCTION

In the circumstances where a person is declared as an insolvent, certain transactions which may
occur either during this process or preceding this process, ought to be avoided to negate any sort
of effect they might otherwise have on the financial position of the Corporate Debtor and thereby
inevitably the creditors. The provisions which enable such avoidance are generally known as the
avoidance provisions and they deal with the ‘avoidance of certain transactions’. They are present
in insolvency laws in almost all international jurisdictions. For example, even in the Companies
Act, Sections 328-331, provides for the avoidance of certain transactions undertaken before or
during or even after the commencement of the winding up proceedings. Similarly, the Code also
includes detailed provisions to ensure that certain transactions are avoided. These transactions are
primarily preferential, undervalued and extortionate credit transaction. Section 25(2)(j) of the Code
casts a duty on the RP to file application for avoidance of transactions, if any, it may be made
during either CIRP or liquidation. These transaction broadly fall under Sections 43 to 51 of the
Code and Section 66 dealing with fraudulent transaction is often tagged along with the same as
there is usually an element of fraud in these avoidance transactions. However, it is to be noted that,
mala-fide intent is not a sine-quo non for proving an avoidance transaction having taken place, as
that is purely a question of fact. For e.g. Even if the CD had no intention to prefer one creditor
over another and thereby improve the creditors’ position, it would still amount to a preferential
transaction under Sec. 43 as under the Code provided it met all the other required elements.

II. PREFERENTIAL TRANSACTION

Preference would mean any sort of bias on the part of the CD, whereby he favours one creditor
over another. Thus, where a creditor is unduly favoured by the debtor, it would invariably
adversely affect the collective interest of all creditors in a liquidation scenario, whereby they might
have received less monies otherwise as compared to the waterfall mechanism under Section 53.
The UNCITRAL Legislative Guide on Law of Insolvency defines “preference” as a transaction
which results in a creditor obtaining an advantage or irregular payment. Section 43 of the Code,
allows for the certain transactions to be avoided if it appears to the RP that they have been preferred
over others which ought to have made in a impartial, ordinary and prudent business manner.

3|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

III. SCHEME OF SECTION 43 OF THE CODE

LIQUIDATOR OR RP FORMING AN ‘OPINION’ [S ECTION 43(1)]

Since these transaction are to be avoided in both the CIRP or Liquidation processes, the appropriate
authority for identifying such transactions is both the liquidator or the RP as the case may be. The
first sub-section provides that where the liquidator or RP, is of the opinion that the CD has within
the relevant time given a preference in a transaction and it is in the manner laid down in sub-section
(2) to any person and within the look-back period as under sub-section (4), he shall then apply to
the Adjudicatory Authority (NCLT) for avoidance of such preferential transactions and pray for
an Order referred to in Section 44.

Regulation 35A of the CIRP Regulations, also provided that on or before the 75 th day of the
insolvency commencement date, the RP shall form an opinion whether the CD has been subjected
to any of the avoidance transactions namely those under Sections 43, 45 and 50 and he shall make
a determination on or before the 150th day of the insolvency commencement date, under the
intimation to the Board. Once the determination is made, he shall file an application to the
Adjudicatory Authority for relied on or before the 135th day of the insolvency commencement day.

MANNER OF PREFERENCE [SECTION 43(2)]

Firstly, there is transfer of property or an interest of the CD for the benefit of a creditor or a surety
or a guarantor. Property and Interest though not defined shall have the general meaning as
understood in several corporate cases.

Secondly, this transfer must be on account of antecedent financial debt, this condition is a sine quo
non for a preferential transaction to take place. Antecedent means pre-existing. Thus, if the debt
existed prior to such preferential transaction, it is antecedent

RELEVANT PERIOD AND LOOK-BACK PERIOD [SECTION 43(4)]

The provision is two-fold and lays down the relevant periods for two types of parties. Firstly, for
related parties, it shall be during the period of two years preceding the insolvency commencement
date and Secondly, for a preference given to a person other than a related party during the period
of one year preceding the insolvency commencement date. Thus the 1/2 years preceding to the
commencement of insolvency is the crucial period and relevant time for preferential transactions.

4|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

IV. EXCEPTIONS TO PREFERENTIAL TRANSACTIONS

Section 43(3) serves as an exclusionary clause and explicitly excludes certain transactions from
the vice of ‘preferential’. This clause shows the legislative intent to provide a defence to the CD
as against the claims made by the RP or liquidator. There are two primary exceptions as laid down
in this provision of the Code, namely;

ORDINARY COURSE OF BUSINESS

Section 43(3)(a) excludes from the ambit of preferential transactions, any transfer made in the
ordinary course of the business or financial affairs of the corporate debtor or the transferee.
However the concern arises due to the phrase ‘ordinary course of business’ which the statute failed
to define the phrase vide an explanation to the section nor is it defined in the Code as such. Thereby
this dearth of definition is often the bedrock for contentious disputes between both the CD
employing the same as a defence and the RP or liquidator rejecting the same.

COMPANY LAW PERSPECTIVE

From a company law perspective, the phrase is found in Section 188 while dealing with RPTs.
However, the Companies Act, 2013 and also the erstwhile 1956 Act has failed to define the same.
Through jurisprudence, it has generally been understood to mean the usual and routine course of
business, customs and practice of certain business. However, before we turn to company law
cases, it is to be kept in mind that the phrase as used in Section 188 of the CA and Section 43(3)(a)
Code might not be the same bearing in mind the objects and purpose of the said clauses. Per rules
of Statutory Interpretation, the phrase must be interpreted in light of the purpose the provision or
the Code ought to serve and further, the provision must be read as a whole.

INSTITUTIONAL INVESTOR ADVISORY SERVICES GUIDELINES

They have laid down a general framework enumerating a list of factors to be taken into
consideration to define whether some particular act would be in the ‘ordinary course of business’
or not. The primary object clause provision in the guidelines might not be relevant for the purpose
of the IBC as the Code comes into effect only during the closure of business and not operation.
However, reference can be made to the guidelines to the three-fold factors of Precedence,
Periodicity and Uniformity (Predictability and Consistency). Thus any transactions which are not
a one-off and occur periodically and uniformly will fall under the phrase and therefore be excluded

5|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

from the ambit of Section 43 and cannot be termed as a preferential transaction.

UNCITRAL FRAMEWORK

The UNICTRAL Legislative Guide on Insolvency Law, defines ‘ordinary course of business’ in
Clause 12(bb) as, “transactions consistent with both the operation of the debtors business prior to
insolvency proceedings; and ordinary business terms”.

DICTIONARY DEFINITIONS

The Blanks Law Dictionary defines the same as, “the normal routine in managing a trade or
business”.

Business Dictionary defines it as, “A term for the activities that are necessary, normal, and
incidental to the business. These are common practices and customs of commercial transactions.”

CREATION OF SECURITY INTEREST

Section 43(3)(b) excludes from the ambit of preferential transactions, any transfer which creates a
security interest in property acquired by the CD, to the extent that it creates a new value as defined
in the explanation to the provision.

RATIONALE

It is an undisputed fact that a secured creditor is better placed than an unsecured creditor in
insolvency/liquidation proceedings. Therefore, when a security is being offered to a creditor, he is
being placed in a better position than other creditors. However, that does not necessarily result in
preference. Grant of security interest, per se, is not preference, but may be proved to be a
preference on fulfilment of certain conditions.

UNCITRAL LEGISLATIVE FRAMEWORK

The UNICTRAL Legislative Guide on Insolvency Law (Part II) while dealing with the same, states
that, (security interests) may nevertheless be avoidable in insolvency proceedings on the same
grounds that any other transaction might be challenged and avoided. The purpose of such an
approach is to prevent a debtor that is not able to pay its debts from encumbering assets, unless the
security interest provided is in consideration of new funds being advanced. Otherwise, the
encumbered assets will not be available to creditors generally and will place restrictions on the
debtor’s use of those assets. A transaction granting a security interest might be avoided on the

6|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

basis that it is a transaction intended to defeat, delay or hinder creditors, or a preferential or

undervalued transaction. In many cases, it will be a preferential transaction because it involves an
existing creditor.

ILLUSTRATIONS

➢ Grant of a security interest shortly before commencement of proceedings, which although

otherwise valid, may be found to have favoured unfairly a certain creditor at the expense
of the rest;
➢ The grant of a security interest to secure a prior debt or on the basis of past consideration
(permitted in some legal systems, but not in others);
➢ Payments to a secured creditor, if the secured creditor is undersecured and is paid in full
within the suspect period.
➢ Where the security interest is granted to a new creditor, the transaction may not be
preferential within the meaning of that category of transaction, but may be covered by
another category.

CONDITIONS TO AVAIL THE EXEMPTION

➢ The security interest should be given at the time of or after signing of a security agreement;
➢ The security agreement should contain a description of the property as “security interest”;
➢ The security interest was used by the corporate debtor to acquire such property;
➢ The transfer was registered with an information utility on or before 30 days after the
corporate debtor receives possession of such property.

V. ANALYSIS OF IDBI V. JAYPEE INFRATECH

INTRODUCTION

The Allahabad Bench of the NCLT held that creation of certain mortgages by Jaypee Infratech
Ltd. in favour of the lenders of its holding company Jaiprakash Associates Ltd. amounted to
preferential, undervalued and fraudulent transactions under the Code. However, we shall look into
the limited scope of how they dealt with the transaction falling under Sec. 43 and the interpretation
of ‘ordinary course of business’ as taken by the Banks, yet rejected by the Bench.

7|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

APPLICATION OF SEC. 43

It may be noted that as per the conditions specified under section 43(2), the debt, the creditor, and
the assets should all belong to the corporate debtor. In this case, the lender in favour of whom the
mortgage was created was not the creditor of the corporate debtor, but it was the creditor of the
holding company. Therefore, the provisions of section 43 are not directly attracted in this case.
However, the NCLT noted that the holding company is also one of the operational creditors of the
corporate debtor. Section 43(2) requires that the transfer should be for the benefit of a creditor of
the corporate debtor. Hence, this being a deeming provision, applies in case of impugned
transaction. The holding company, which is a creditor of the corporate debtor, is put in a beneficial
position, than it would have been in the event of distribution of assets made in accordance with
section 53. Thus, though not in its traditional sense, the Bench did find its way to apply Sec. 43.

FOUR -POINT TEST FOR PREFERENTIAL TRANSACTIONS

The NCLT stated that a transaction would be classified as “preferential” when:

i. A resolution professional formed an opinion that a corporate debtor,

ii. had at the relevant time;
iii. given preference to a related party:
iv. in the manner prescribed under Section 43 (2) of the Code.

Here, it was not in dispute and the 4 point test passes with flying colours subsequent to the
aforementioned indirect reading to include the interaction of a lender with a third party. However,
the bone of contention still remains as to whether the exclusion provision under Sec. 43(3)(a) is
applicable or not.

ORDINARY COURSE OF BUSINESS

The Banks in question i.e. ICICI and Standard Chartered, had in essence acquired a security
interest through the impugned transaction as against their credit extended to Jaiprakash Associates,
the holding Company of Jaypee Infratech. The Banks in this instant case, sought to take the defence
of Sec. 43(3)(a) and argued that, it is customary for banks to seek credit enhancement through
creation of security interest by borrowers and their group companies.

The NCLT however, dismissed this on the ground that, the language of the exclusion clause and
the use of the wording ‘transfer made’, would mean, the ordinary course of business refers solely

8|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

to the ordinary course of business of the transferor (Jaypee) and not the transferees (Banks). They
held, a transfer made by the transferor for the benefit of its related party without any counter
guarantee or consideration could not be considered a transaction in the ordinary course of business.
Thus, they concluded that the exclusionary clause is not attracted and thereby the impugned
transaction is preferential and stands foul of Section 43 of the Code.

CONTRADICTORY N ATURE

Principally speaking, the finding of the NCLT is well-reasoned and is well-founded on logic and
the law. Though, it seems true that by using ‘transfer made’, and the scheme of the provision, the
ordinary course of business referrers to that of the CD and not the lender.

However, the very wording of Section 43(3)(a) reads as follows:

“Transfer made in the ordinary course of the business or financial

affairs of the corporate debtor or the transferee.”

Thus, the expression mention of ‘or the transferee’ must mean that the ambiguous phrase would
include the business of the CD and the transferee and thus, the reading of the clause per the NCLT
order though reasoned, runs contrary to the literal wording of the provision.

VI. SUGGESTION

It is suggested so as to amended Sec. 43(3)(a) to delete the phrase ‘or the transferee’. Any
transaction which benefits the transferee, i.e. the CD, ought to be in his ordinary course of business
and therefore the requirement of including transferee is redundant to that extent and introduces a
certain level of unnecessary ambiguity and perpetuates several lenders to employ this clause
seeking, the impugned transaction is in their ordinary course of business

VII. CONCLUSION

There is immense importance to Section 43 and all other avoidance transactions as well as they
prevent the CD from favouring those creditors he prefers based on other considerations and thereby
prejudice the bonafide interests of the other creditors. Thus, there is a requirement that the
defaulters aren’t provided with an opportunity to take up certain loopholes and ambiguities.
Therefore, the amendment would ensure the legislative intent is fully brought out and creditors are
protected and any preferential transactions would be rightly avoided.

9|Page
IBC PROJECT PREFERENTIAL TRANSACTIONS

VIII. REFERENCES

LEGISLATION AND RULES

➢ The Insolvency and Bankruptcy Code, 2016

➢ Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate
Persons) Regulations, 2016

ONLINE SOURCES

➢ Nishith Desai Associates, Vulnerable Transactions under the Bankruptcy Code: Promoters
and Lenders Both Beware (Oct. 25, 2018),
http://www.nishithdesai.com/information/news-storage/news-details/article/vulnerable-
transactions-under-bankruptcy-code-promoters-and-lenders-both-beware.html
➢ Singh & Associates, India: Avoidance of Specified Transactions (Sept. 1, 2017),
http://www.mondaq.com/india/x/625268/Insolvency+Bankruptcy/AVOIDANCE+OF+SP
ECIFIED+TRANSACTIONS
➢ Sikha Bansal, Security Interests as Preferential Transactions (May 15, 2018),
http://vinodkothari.com/wp-content/uploads/2018/05/Security-Interests-as-Preferential-
Transactions.pdf
➢ Sikha Bansal, Jaypee Infratech Case: Discerning the reach of Avoidance Proceedings (May
22, 2018), https://indiacorplaw.in/2018/05/jaypee-infratech-case-discerning-reach-
avoidance-proceedings.html

LEGAL DATABASES

➢ Manupatra
➢ SCC Online

CASE LAW

➢ IDBI Bank Limited v. Jaypee Infratech Limited, MANU/NC/5257/2018

10 | P a g e