Fraudulent Transactions: What to Keep in Mind While Ring-Fencing Your Assets

Solomon and Co.

Introduction

In light of the worldwide Covid-19 pandemic and the resulting financial slump in the country many companies are likely to find modes to ring fence their assets for better security and protection. Some distressed companies may also look at ring fencing their assets to secure them from any corporate insolvency resolution process (“CIRP”) that these distressed companies may be at the brink of. While doing so, the companies have to ensure that such transfers are in their ordinary course of business and such transfers are not undertaken with an intent for tax evasion or for constituting a fraud or preferential treatment to the creditors. The Insolvency and Bankruptcy Code, 2016 (“the Code”), the Companies Act, 2013 and Transfer of Property Act, 1882 provides for provisions for setting aside any transfers that have been effected with an intent to defraud the creditors of a company. This article enlists various kinds of fraudulent transactions that can be set aside by the Court under the above-mentioned enactments.

I.     The Code:

The Report of Bankruptcy Law Reforms Committee 2015 had discussed the possibility of identifying and recovering from vulnerable/fraudulent transactions. These are transactions that fall within the category of wrongful or fraudulent trading by the entity, or unauthorized use of capital by the management. There are two concepts that are recognized in other jurisdictions under this category of transactions: fraudulent transfers, and fraudulently preferring a certain creditor or class of creditors. If such transactions are established, then they will be reversed. Assets that were fraudulently transferred will be included as part of the assets in liquidation. The Committee recommended that all transactions up to a certain period of time prior to the appointment of the interim resolution professional (referred to as the “look-back period”) should be scrutinized for any evidence of such transactions by the relevant Insolvency Resolution Professional (“IRP”).

Accordingly, under the Code, Sections 43, 45, 49, 50 and 66, deal with transactions that can be avoided or set aside by the IRP and the Liquidator. These transactions are of five categories:

  1. Preferential transactions
  2. Undervalued transactions
  3. Undervalued transactions defrauding the creditors
  4. Extortionate credit transactions
  5. Fraudulent trading or wrongful trading

The intention of legislature behind enacting such provisions is that fraudulent transactions are avoided so that such assets would be available either with the IRP or with the liquidator, as the case may be, to put the corporate debtor back on its wheels or if that is not possible, to ensure that the creditors of the corporate debtor get a fair deal.

Relevant Period / Look-back Period under the Code: The relevant time period for these transactions to be challenged is 2 years preceding the insolvency commencement date in the case of transaction with a related party and 1 year in case of any other person.

A.     Preferential and undervalued transactions – entered into for the benefit of one creditor at the relevant period (Section 43):

  • A transaction shall be considered a preferential transaction if there has been a transfer of property of an interest in respect of an existing debt or liability and such transfer has the effect of putting such creditor in a beneficial position than it would have been in the event of a distribution of assets u/s 53 of the Code. But any transfer which is made in the ordinary course of business or which creates a security interest in the property acquired by the corporate debtor shall not be a preferential transaction. The transaction should further fall within the ‘relevant time period’ for it to be preferential.
  • The Hon’ble Supreme Court has, in the matter of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited Vs Axis Bank Limited Etc., (Civil Appeal Nos. 8512-8527 of 2019), held that the transfers and mortgages created by Jaypee Infratech Limited for the benefit of the lenders of its holding company Jaiprakash Associates Limited were made to defraud the creditors of the corporate debtor Jaypee Infratech Limited and were not made in ordinary course of business or financial affairs of the corporate debtor. Jaypee Infratech Limited, whose ordinary course of business was of ensuring execution of housing/building projects, had inflated itself to routinely mortgaging its assets and/or inventories to secure the debts of its holding company, and that too, at the cost of its own financial well-being.
  • The Apex Court while setting aside these transactions as being of deemed preference to related party by the corporate debtor during the look-back period of two years and thereby covered within the period envisaged by Sub-section (4) of Section 43 of the Code, laid down that while considering whether a transaction is preferential or not has to answer the following questions:
    • As to whether such transfer is for the benefit of a creditor or a surety or a guarantor?
    • As to whether such transfer is for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor?
    • As to whether such transfer has the effect of putting such creditor or surety or guarantor in a beneficial position than it would have been in the event of distribution of assets being made in accordance with Section 53 of IBC?
    • If such transfer had been for the benefit of a related party (other than an employee), as to whether the same was made during the period of two years preceding the insolvency commencement date; and if such transfer had been for the benefit of an unrelated party, as to whether the same was made during the period of one year preceding the insolvency commencement date?
    • As to whether such transfer is not an excluded transaction in terms of Sub-section (3) of Section 43?
  •  
  • Examples of preferential transactions may include:
    • payment or set-off of debts not yet due;
    • performance of acts that the debtor was under no obligation to perform;
    • granting of a security interest to secure existing unsecured debts;
    • unusual methods of payment, for example, other than in money, of debts that are due;
    • payment of a debt of considerable size in comparison to the assets of the debtor; and;
    • in some circumstances, payment of debts in response to extreme pressure from a creditor, such as litigation or attachment, where that pressure has a doubtful basis.
    • A set-off, while not avoidable as such, may be considered prejudicial when it occurs within a short period of time before the application for commencement of the insolvency proceedings and has the effect of altering the balance of the debt between the parties in such a way as to create a preference or where it involves transfer or assignment of claims between creditors to build up set- offs. A set-off may also be subject to avoidance where it occurs in irregular circumstances, such as where there is no contract between the parties to the set-off.

B.    Undervalued transactions at the relevant period (Section 45): An undervalued transaction, has to have the following requisites:

  •  The corporate debtor has to make a gift to a person; or
  • enter into a transaction for transferring a property to a person at a value of consideration significantly lower than the consideration paid by the corporate debtor of such property or provided in their books of account.
  • Such transactions have not been undertaken during the ordinary course of business of the corporate debtor. The concept of ordinary course of business would be the same as considered under preferential transactions.

While deciding whether a transaction is an undervalued transaction, the Tribunal has the power to seek an independent expert to assess evidence relating to the value of the undervalued transactions.

C.     Undervalued transactions entered into for defrauding the creditors (Section 49):

  1. The undervalued transactions as defined above entered with mala fide intentions to defraud the creditors by putting the assets of the corporate debtor beyond the reach of creditors or otherwise to prejudice the interest of the creditor who would be entitled to make a claim against the corporate debtor and adversely affect the interests of the said creditor, are covered under this very provision. The important element required for attracting section 49 is that there should be deliberate act on the part of corporate debtor to enter into an undervalued transaction.

Exceptions to the above:

    • if any interest in property was acquired from a person other than the corporate debtor; and
    • was acquired in good faith, for value and without notice of the relevant circumstances
  1. In case of an undervalued transaction entered with an intent to defraud a creditor, while protecting the interests of persons who are victims of such transactions, the Tribunal has the power to restore the position of the corporate debtor as it existed before such transaction as if the transaction had not been entered into.

D.     Exorbitant credit transaction (Section 50):

  1. A transaction shall be considered an exorbitant credit transaction if the corporate debtor obtains any credit facility with exorbitant rate of interest or unfair credit terms such as incorporating severe default provision or was in a vulnerable position at the time of the transaction. The relevant period under this provision is 2 years preceding from the insolvency commencement date.
  2. The only exception for section 50 is if the credit facility is extended by any person providing financial services which is in compliances with any law for the time being in force in relation to such debt. Then such transaction will not be considered as extortionate credit transaction.
  3. While deciding an issue of exorbitant credit facilities, the Tribunal has been provided with the following powers to:
    • Restore the position as it existed prior to such transaction
    • Set aside the whole or part of the transaction of debt
    • Modify the terms of transaction
    • Require any person who is a party to the transaction to repay any amount received
    • Relinquish the security interest created out the transaction in favour of liquidator or IRP.

E.     Fraudulent trading or wrongful trading (Section 66):

  1. If during the corporate insolvency resolution process or a liquidation process, it is found by the IRP or liquidator that any business of the corporate debtor was carried on with the intent to defraud the creditors or for any fraudulent purpose, the adjudicating authority can direct any person who was knowingly carrying out the business in such fashion, to contribute to the assets of the corporate debtor.
  2. A director or partner of the corporate debtor can be directed to contribute to the assets of the corporate debtor:
    • If before the insolvency commencement date, such director or partner knew or ought to have known that the there was no reasonable prospect of avoiding the commencement of a CIRP in respect of such corporate debtor; and
    • such director or partner did not exercise due diligence in minimising the potential loss to the creditors of the corporate debtor.

3. The NCLT, Allahabad in IDBI Bank Ltd. versus Jaypee Infratech Limited[1] had ruled that a transaction to secure the debt of a related party and to prevent preservation of value of the assets of the corporate debtor shall clearly be a fraudulent and wrongful transaction under Section 66 of the Code if it has been carried on with the intent to defraud the creditors of the corporate debtor. In the said case, since the corporate debtor itself was in dire need of funds for completing construction of flats and could have sold, mortgaged, unencumbered land to raise funds to complete construction of flats in a timely manner and to fulfil its obligation to its creditors, but, it chose to give away the land to secure the debt of a related party. Further, the directors were also held to be aware that they were in twilight zone and insolvency was imminent and that they did not exercise due diligence in minimizing the potential loss to the Financial Creditors, Operational Creditors, creditors (including home buyers) and other stakeholders of the Corporate Debtor. The transactions carried out by the Corporate Debtor were held to be fraudulent under Section 66, 43 and 45 of the Code. The said finding was also confirmed by the Apex Court.

4. Hence, Section 66 is read in consonance with Section 43, 45 and 49 of the Code.

Immunity granted to the Corporate Debtor

Newly introduced Section 32A[2] of the Code inter-alia, provides immunity to a corporate debtor and its assets from any prosecution, action, attachment, seizure, retention or confiscation upon approval of a resolution plan if the resolution plan results in the change in the management or control of the corporate debtor. The said Section 32 A to the Code was introduced in the wake of the CIRP of Bhushan Power & Steel Limited in the JSW Case[3] and the issues pertaining to its assets being attached by the Directorate of Enforcement of Central Government.

Section 32A provided that the prior liability or the offence committed by the corporate debtor will be ceased and discharged once the resolution plan is approved by the adjudicating authority if there is change in the management and control of such corporate debtor and there is a new management in place, then such new management shall not be prosecuted for such earlier offence of the corporate debtor. It further provides that such an exemption shall be given if the new management is in the control of a person who was not –

  • A promoter or in the management and control of the corporate debtor or a related party of such a person; or
  • A person with regard to whom the relevant investigating authority has reason to believe that he has abetted or conspired for the commission of an offense and a report or complaint has been filed against him.

The corporate debtor shall cease to be liable for any transaction of assets considered to be fraudulent if such assets form part of the resolution plan which gets approved by the Adjudicating Authority.

However, it also mentions that every person who is a designated partner as defined in the Limited Partnership Act or an officer as defined in Clause 60 of Section 2 of the Companies Act 2013 who is in charge of the business of the corporate debtor and is directly or indirectly in the commission of such offence as per report or complaint filed by the investigating authority shall continue to be liable and prosecuted for such offence committed by the corporate debtor notwithstanding that the liability of the corporate debtor has ceased.

It is pertinent to note here that there is a dichotomy of views as regards the criminal proceedings and proceedings by special authorities like CBI, EOW or Enforcement Directorate and whether Section 32A shall have an overriding effect over such proceedings as well. The decision on the same is pending before the Supreme Court of India.

The intent and purpose of the insertion of Section 32A is to provide certainty to the ‘Resolution Applicant’ that the assets of the ‘Corporate Debtor’ as represented to him and for which he proposes to pay value/consideration in terms of the ‘Resolution Plan’, would be available to him in the same manner as at the time of submissions of the ‘Resolution Plan’.[4]

II.     Fraudulent transactions under the Companies Act 2013

Section 328 and 329 of the Companies Act, 2013 are similar to the provisions of preferential transaction under the Code which are not done in the ordinary course of business, with two things to be kept in mind[5]:

  • First, the dominant motive in the mind of the company (as represented by its directors or general body of shareholders) should be to prefer a particular creditor.
  • Second, the said act must be undertaken during the period of six months preceding the filing of the winding up petition of the company.

While the first requirement ensures that the dominant intention to defraud creditors is detected, the second ensures that there is a level of commercial certainty and finality of transactions for those interacting with the company.

Section 329 of the Companies Act, 2013 further lays down that if the transfer of property by a company not done in the ordinary course of business or not being an encumbrance in good faith and for valuable consideration shall be void if such transfer is made within a period of one year before filing for winding up or the passing of a resolution for voluntary winding up of the company. For both the sections fraudulent intent to defraud the creditors have to be present.

III.     Fraudulent transactions under the Transfer of Property Act, 1882

Section 53 of the Transfer of Property Act, 1882 (“TOPA”) recognizes the need to protect the interest of the creditors of the transferor. The rule of equity, justice, and good conscience has been incorporated in this section. It prevents a person from defeating the legitimate claims of his creditors. Section 53 of TOPA puts a restriction on any such transaction that is not made with a bonafide intention. For the purpose of this section, a transfer is made with a fraudulent intention when it intends to defeat the interest of creditor or interest of any subsequent transferee. Where the transfer is made with a fraudulent intention, the object of the transfer would be bad in the eyes of equity and justice, even though it would be valid in law.

Under Section 53 of TOPA there must be a transfer of an immovable property. The transfer must be a real one which creates a vested title in favour of the third party and the transferor is no more the real owner of the property. The basic objective behind this section is to protect the creditors from being delayed or defeated by removing the possible security. Any transaction shall be hit by Section 53 of TOPA, if such transaction has been done with the fraudulent intention to make the property unavailable for the purpose of security to be given to a creditor. Hence, like under the Code and the Companies Act, 2013, the intention behind the transfer must be to defeat or delay the creditors.

Conclusion

The key take-aways from this article shall be that for the transactions to not come under the ambit of fraudulent or preferential transactions, such impugned transactions must not fall within the ‘look-back period’, such transactions must be in the ordinary course of the business. It is pertinent to note here that the intention behind any transaction with respect to transferring of assets of the company must not be of defrauding its creditors but instead for the benefit of the company and its financial health. The provisions under the Code, the Companies Act, 2013 and TOPA empowers the IRPs to set aside such transactions with the help of the powers vested with the Courts to reverse the effect of such transactions and put the company back in the position as if such transaction had not taken place.


About the Authors

Saumya Brajmohan is a Senior Associate (Litigation) at Solomon & Co. She can be reached here.

Sharda Srivastava is an Associate at Solomon & Co. She can be reached here.

About Solomon & Co.

Solomon & Co., (Advocates & Solicitors) was founded in 1909 and is amongst India’s oldest law-firms. The Firm is a full-service firm that provides legal service to Indian and international companies and high net-worth individuals on all aspects of Indian law.


Photo Credits: Chris Hondros/Bloomberg

Notes:

[1] CA No.26/2018 in Company Petition No.(IB)77/AD/2017

[2] Insolvency and Bankruptcy Code (Amendment) Act, 2020 – 13th March, 2020

[3] JSW Steel Ltd. and Ors. v. Mahender Kumar Khandelwal and Ors. Company Appeal (AT) (Insolvency) No. 957

of 2019, NCLAT decided on 17th February 2020

[4] Ibid.

[5] IDBI Bank Limited Through DGM v. The Official Liquidator, Office of the Official Liquidator of Companies &

Anr., SLP (CIVIL) NO. 33825 OF 2009, Supreme Court decided on 17th October, 2019

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