The Insolvency and Bankruptcy Code, 2016 lists four types of vulnerable transactions, namely Preferential, Undervalued, Fraudulent, and Extortionate. PUFE Transactions are covered under sections 43, 45, 66, and 50 of IBC. The Covid-19 pandemic have caused consolidation transactions to increase drastically in the future. Many businesses may not have sufficient financial wherewithal to survive the crisis and will look to sell out. At the same time, there will be Buyers who will have enough cash to be deployed in taking over distressed businesses. In such distressed asset sale transactions, the buyer needs to be cognizant in the event of the Seller's insolvency.

It is important to prevent distressed companies from takings measures that could hamper recovery to creditors. There could be a risk of the Transaction being challenged as a PUFE Transaction and therefore, the resolution professional while facilitating the resolution of the corporate debtor, is duty-bound to form an opinion and identify such transactions and report them to the adjudicating authority for the appropriate relief, in cases where the Seller has been subjected to a PUFE transaction.

Preferential Transactions, AMLEGALS

Preferential transactions

Under the Insolvency and Bankruptcy code 2016, Section 43 is dealt with Preferences if any given by the Corporate Debtor before and during the insolvency. Usually, in a distressed sale, the sale proceeds received by the Seller would be used to repay the Seller’s lenders or creditors. The encumbrances, if any, on such assets would be released by the lenders upon receipt of the sale proceeds. In such a situation, if the NCLT holds that such repayment was a preferential transaction by the Seller in favor of the relevant lenders, a question could arise whether the Transaction could be challenged at a later date.

Preference is said to be given if-

a. Transfer of property happens for the benefit of creditor / surety / guarantor for, or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor; and

b. Such transfer puts the creditor in beneficial position than what he would have been obtained, in the event of distribution of assets being made in accordance with Section 53.

c. The transfer should be done within the relevant period. The relevant period should be 2 years for related party and 1 year for other parties preceding the date of commencement  of insolvency of the corporate debtor.

Such transaction is reversed under Section 44. The reversal includes the asset and the benefit derived by the beneficiary. Example: Usurious interest rate, excessive guarantee commission given. Breach of financial covenant with secured creditor will be often involved in such a case.

Exclusions of Preference:

The following are not considered to be in Preference:

1. transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee;

2. 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.

IDBI Bank Ltd. v. Jaypee Infratech Ltd is a perfect example of transaction to be considered as Preferential transaction. In this case, M/s JaiPrakash Associated (JAL) was holding company and M/s Jaypee Infratech Ltd. (JIL) was a subsidiary company. JAL had promoted a special Purpose company JIL for undertaking certain design, engineering, development, and construction of projects. JAL was having 70% of the shares in JIL. Later JIL started facing financial difficulties and failed to honor its project completion details and loan repayment obligations. As a result LIC, declared the account of JIL as NPA. Since the account of JIL was classified as NPA , their financial creditors (IDBI) filed an application in the NCLT under section 7 and Resolution Professional, filed an application in the NCLT seeking the transaction as Preferential transaction under section 43 of IBC.

The Allahabad Bench of the National Company Law Tribunal (''NCLT'') observed that, the timing of entry of the transaction by JIL was questionable and JIL had entered into this transaction when it was facing severe financial difficulty. JIL has not acted diligently for reducing the loss to the creditors and mortgaged the land without counter guarantee from JAL. Further JIL had not taken necessary approvals from the JLF lenders and also from the shareholders for the impugned transaction. The Tribunal further observed that, the impugned transactions were entered into within the relevant period and are preferential transactions under Section 43 of the Code.

Undervalued Transactions

Undervalued Transaction is with dealt under Section 45 of the Insolvency and Bankruptcy code 2016. Under Section 45(2) of the IBC, a transaction is considered to be undervalued if 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.

An undervalued transaction with a related party could be questioned within 2 years, and with a non-related party, it could be questioned within 1 year, preceding the insolvency commencement date. Besides the liquidator or RP, a creditor, member (in case of a company) or, a partner (in case of a limited liability partnership (LLP)) of a corporate debtor, can apply to the NCLT to declare Transactions void and reverse their effect. On such an application, if the NCLT determines that the Transaction was undervalued and the same was not reported by the RP or liquidator in spite of having sufficient information or opportunity to avail information of the Transaction, the NCLT can order restoration of the position as it was, prior to the Transaction and require the insolvency board to initiate proceedings against the liquidator or RP. Example: Lease transaction with very low lease rental. Such transactions invariably involve other serious non-compliances.

The NCLT can require an independent expert to assess evidence of the Transaction value. If it is proved during the insolvency proceedings that the Transaction had been undervalued, the Transaction can be declared as void, and the Buyer and the Seller can be required to reverse the effect of the Transaction. The NCLT could also pass an order inter alia-

a. requiring the transferred property to vest in the Seller;

b. requiring the Buyer to pay such consideration as may be determined by an independent expert; or

c. require any person to pay such sums, in relation to the benefits derived by such person to the liquidator or RP.

If the NCLT determines, that the Seller entered into the Transaction deliberately:

a. for keeping assets beyond the reach of a person who may have a claim on such assets or

b. to adversely affect the interest of such person in relation to the claim; then the NCLT is required to pass an order-

i. restoring the position that existed before the Transaction, and

ii. protecting the interest of the victims of the Transaction. In such a situation, the NCLT will protect the Buyer if-

a. the Buyer entered into the Transaction in good faith, for value and without notice of the relevant circumstances, or

b. the Buyer acquired the business or asset from the Seller (and not directly from the corporate debtor) in good faith, for value and without notice of the relevant circumstances.

Fraudulent Transactions, IBC Guide.

Fraudulent trading/transactions

Section 66(1) of Insolvency and Bankruptcy Code, 2016, deals with fraudulent trading. If it can be proved during the insolvency process that the Seller carried on any business with the intent to defraud creditors or for any fraudulent purpose, the NCLT can pass an order directing any persons who were knowingly parties to the carrying on of the business in such manner, to be liable to make such contributions to the assets of the Seller, as NCLT may deem fit. While section 66(2) deals with wrongful trading, that is, the conduct might not amount to fraud but may fall short of principles governing duties of directors to act diligently in the vicinity to insolvency. The Adjudicating Authority makes the director or partner liable to compensate for the loss.

A significant implication of a transaction being found to be fraudulent is the penalty that may be attracted in each case. Under Section 69 of the IBC, officers of a company that has undertaken such fraudulent transactions may be punishable with imprisonment for a term of up to five years and a fine extending up to rupees one core. No such penalty is prescribed for undervalued transactions. During the insolvency proceedings, the Buyer should be able to prove that the Buyer acted in good faith and has paid the fair value. To prove good faith, it should be proved that the Buyer had carried out the necessary due diligence and did not know of the impending insolvency. In order to mitigate the risk of the Transaction being struck down at a later date, parties should-

a. obtain one or two valuation certificates from well reputed, independent and preferably, government registered values in respect of the property to be transferred;

b. if possible, obtain consent of all stakeholders (such as shareholders, partners, creditors, etc) who could object; and

c. the Seller could conduct a bidding process inviting offers from third parties (including by way of public advertisement or appointing intermediaries such as investment banks) to determine the fair value.

The Supreme Court in M/s Embassy Property Developments v. State of Karnataka & Ors. laid down that NCLT and NCLAT have the jurisdiction to inquire into fraudulent transactions under section 66.

Extortionate Transactions

Under Section 50 of the Insolvency and Bankruptcy Code, 2016, an extortionate transaction is one that involves the receipt of financial or operational debt within two years preceding the insolvency commencement date at terms requiring exorbitant payments to be made by the corporate debtor may be avoided by an order of the NCLT. Here excessive returns are provided to such creditor. This section does not apply if any debt extended by a person is in complies with the law.

If the NCLT finds that the terms of the credit transaction required exorbitant payments to be made by the Seller, NCLT can inter alia order to-

a. restore the position as it existed prior to the Transaction;

b. set aside the whole or part of the debt attributable to the extortionate credit transaction;

c. modify the Transaction terms;

d. require any person who was a party to the extortionate transaction to repay any amount so received by such person;

e. require the release of security interest created by the corporate debtor for the extortionate transaction in favor of the liquidator or RP.

The Relevant Period for a transaction to be an Extortionate transaction is during the period within two years preceding the date of commencement of insolvency.

Hence, it is clear that the contracting parties and creditors have to ensure that they have access to the latest financial position of a company before entering into any transaction, particularly those involving transfer of assets or value from such a company. In the event of any signs of financial distress, the risk of any such transaction being avoided should be appropriately considered and weighed.

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