Insolvency & BankruptcySupreme Court Guidelines on Identification of Preferential Transactions

IN THE SUPREME COURT OF INDIA

Anuj Jain v. Axis Bank Limited & Anr.

[Civil Appeal No. 8512-8527 of 2019] | Date: 26.02.2020

FACTS

Corporate Debtor, Jaypee Infratech Limited (“JIL”) is a subsidiary company of Jaiprakesh Associates Limited (“JAL”), which is a Public Listed Company. JIL was set up as a special purpose vehicle for construction works.

JAL had obtained finance from a consortium of banks and financial institutions, including ICICI Bank Limited, Standard Chartered Bank Limited and State Bank of India (“JAL Lenders”) against the land mortgaged by JIL as a security.

JIL was declared a NPA by Life Insurance Corporation of India on 30^th September 2015 and by some of its other lenders on 31^st March 2016.

IDBI Bank Limited, a creditor of JIL, filed a petition under Section 7 of the Insolvency and Bankruptcy Code, 2016 (“Code”) before the National Company Law Tribunal, Allahabad Bench (“NCLT”) for seeking initiation of Corporate Insolvency Resolution Process (“CIRP”) against JIL for alleged default in repayment of dues.

NCLT initiated CIRP against JIL on 9th August 2017 and a Resolution Professional was appointed to manage the activities of JAL.

The Resolution Professional upon noticing the impugned transactions filed an application before the NCLT, seeking declarations that the impugned transactions were fraudulent, undervalued and preferential transactions under the Code.

The NCLT on 9th May 2018 and 15th May 2018 approved the decision of the Interim Resolution Professional of JIL and ordered :

1. the release and discharge of the security interest created by JIL, and

2. that the properties mortgaged by way of the impugned transactions be deemed to be vested in JIL.

An appeal was filed against the order of NCLT where, the National Company Law Appellate Tribunal, New Delhi (“NCLAT”) on 1st August 2019 by a common order set aside the NCLT order dated 16th May 2018.

NCLAT also allowed the appeals filed by the lenders of JAL and held them to be financial creditors of the Corporate Debtor.

Thereafter, various appeals were filed before the Supreme Court on the NCLAT order dated 1st August 2019, which brings the Court to the present judgment.

ISSUES BEFORE THE SUPREME COURT OF INDIA

1. Whether the transactions in question deserve to be avoided as being preferential, undervalued and fraudulent, in terms of Sections 43, 45 and 66 of the Code.

2. Whether the Respondents (lender of JAL) could be recognized as financial creditors of the Corporate Debtor based on the mortgage created by the Corporate Debtor, as a collateral security of the debt of its holding company JAL.

CONCLUDING VIEW

The Court while analysing the First Issue, firstly enumerated on the concept of preference and held that it was an act of payment by an insolvent debtor, whole of part of the claims, to the exclusion of the rest of the creditors.

Preference transactions are “transactions ‘where the insolvent debtor makes a transfer to or for the benefit of a creditor so that such beneficiary would receive more than what it would have otherwise received through the distribution of bankruptcy estate.”

The Court held that it was not necessary to deal with the issues of whether the impugned transactions were also undervalued and/or fraudulent.

While holding so, the Court provided its opinion on distinction between Section 43 and Section 45, 49 and 66 of the Code. The Court held Section 43 is a “deeming provision” and therefore, no intent was required in the violation of Section 43. All there has to be is a simple non-fulfilment of the requirements of Section 43. On the other hand, Sections 45, 49 and 66 required an element of intent for the act committed.

The Court interpreted Section 43 of the Code and held that if the ingredients of a preferential transaction is fulfilled in a transaction, then the preference would be deemed to given by the Corporate Debtor to the Creditor. It was categorically noted that even though the provisions pertaining to preferential transactions were required to be considered in strict sense, the basic purpose and object of the provisions should not be lost while interpreting the same. 

The Court concluded that the creation of mortgage by JIL vide the impugned transactions satisfied the ingredients of a preferential transaction under the Code as follows:

1. The transfer of property/interest was for the benefit of a creditor:

The Court held that for distribution of assets of JIL during liquidation under Section 53 of the Code, JAL was much lower in priority than the other creditors of JIL. However, through the impugned transactions, JAL was put in an advantageous position as compared to JIL’s other creditors because JAL had received working capital from the lender banks in favour of whom JIL had mortgaged its assets. Furthermore, the impugned transactions had the effect of reducing JAL’s liability towards its own lenders.

The Court opined that the repercussion of the advantageous position of JAL corresponded to the detriment of JIL’s other creditors as the security mortgaged by JIL through the impugned transaction cannot form part of the remaining assets that could be made subject to liquidation.  

The underlying ingredient herein as identified by the Court was that the transaction involved a transfer of an asset of the Corporate Debtor for the benefit of the creditor than it would have otherwise usually received during distribution of assets of the Corporate Debtor in accordance to the liquidation waterfall under Section 53 of the Code.

2. The transfer was on account of an antecedent financial/operational debt or other liabilities owed by the corporate debtor:

The Court observed that JIL owed debts and other liabilities towards JAL. JAL was the largest shareholder in JIL holding approximately 71 % of shares and it was also the providing significant finance, technical and strategic support to JIL. Further, JAL had executed bank guarantees in favour of JIL and promoter support agreements with JIL’s lender in order provide JIL with the possible assistance to comply with its obligations towards the lenders.

After analysing these facts Court was of the view that JIL owed antecedent debts and other liabilities towards JAL.

The underlying ingredient herein as identified by the Court was that the transaction involved a transfer of an asset of the Corporate Debtor for the benefit of the credit against a financial debt owned by the Corporate Debtor to the creditor.

3. The transfer was for the benefit of a related party during the look back period:

The Court adjudicated that the JAL was clearly as related party of JIL and all the transaction were entered during last two years before i the date of initiation of Corporate Insolvency Process as provided under Section 46(1)(ii) of the Code. Hence, the transactions were entered into during the look back period as provided under the Code with respect to related parties.

Therefore, the underlying ingredient to be determined herein is whether the transaction was entered

1. During two years preceding the Corporate Insolvency commencement date where the beneficiary was a related party; or
2. During one year preceding the Corporate Insolvency commencement date where the beneficiary was some other person.

4. The transfer was not in the ordinary course of business/financial affairs of the corporate debtor and the transferee:

The Court affirmed the averments of the Resolution Professional that in Section 43 (3) the word, “or” should be read as “and” if it is warranted to bring the provision in question in sync with the intention of the legislature, to curb preferential transactions and reduce loss incurred by the creditors due to the preferential transaction.

The Court relied on the definition of “ordinary course of business” in the landmark case of Downs Distributing Co. v. Associated Blue Star Stores, (1948) 76 CLR 463, wherein it was held to mean “a transaction that falls into place as part of the undistinguished common flow business done”.

Hence, the Court ruled that under Section 43 only those transactions entered into in the ordinary course of the Corporate Debtors’ business/financial affairs, could they be regarded as not creating a preference in favour of one creditor over the other.

However, if the transactions of ordinary course of business/financial affairs are considered then the transfers may be excluded from being construed as preferential transaction, that is not the purpose of Section 43 of the Code.

The Court held that the ordinary course of business/financial affairs of the JIL cannot be that of providing mortgages to secure loans and facilities obtained by its holding company, that too at the cost of its own financial health.  Thus, the transactions were neither in the ordinary course of business/financial affairs of corporate debtor JIL nor did they secure new value in the property acquired by corporate debtor JIL and hence are not excluded transactions under Section 43(3).

Accordingly, the Court held that the impugned transactions were preferential transactions under Section 43 of the Code.

 The underlying ingredient to be determined herein is that whether the transactions were not excluded from being construed as preferential transaction because:

1. Transfer was made in the ordinary course of business/financial affairs of the Corporate Debtor and the transferee; or

2. Transaction creating security interest secured a new value in term of good, services, credit, money etc in the property acquired by the Corporate Debtor or was secured to release any previous transfer.

With regards to the Second Issue, the Court firstly opined that in order to term any lender as financial creditor, the transaction should fulfil the threshold of financial debt.

Thereby, the Court placed reliance over the case of Pioneer Urban Land and Infrastructure Ltd. & Anr. v Union of India & Ors, (2019) 8 SCC 416, wherein the Court identified three essential ingredients of financial debt, i.e. Disbursement, Borrowing and, Consideration for time value of money.

Further, the Court referred to the case of Swiss Ribbons Pvt. Ltd. & Anr. Vs. Union of India & Ors., (2019) 8 SCC 17, wherein the Court had held that it is the financial creditor who lends finance on a term loan or for working capital that enable the Corporate Debtor to set up and/or operate its business; and who has specified repayment schedules with default consequences.

The most important feature, as the Court held, it that a financial creditors is, from the very beginning, involved in assessing the viability of Corporate Debtor who can and indeed engage in restructuring of the loan as well as reorganisation of the Corporate Debtor’s business when there is financial stress.

However, the Court held that the mortgage created in the present case, being neither towards any loan, facility or advance directly availed by JIL nor towards protecting any facility or security of JIL. Thus, it cannot be said that the JIL owes the lenders of JAL any financial debt within the meaning of Section 5 (8) of the Code and hence, the lenders of JAL do not fall in the category of being Financial Creditors of JIL.

AMLEGALS REMARKS 

The Court for the first time herein has laid down a checklist and principles to be followed by a resolution professional in order to identify and avoid preferential transactions under Section 43 of the Code.

The distinction provided by the Code between Section 43 and Sections 45, 49 and 66 is also insightful as it will reduce the dilemma of resolution professional in bringing a transaction under the realm of preferential transaction or fraudulent or undervalued transaction.

Further, the Court made it clear by this judgment that, lending institutions, are required to ensure that their due diligence spans both the entity to whom a loan is provided, as well as the entity which is furnishing the security interest, and the relationship between the two entities. Such institutions must be extremely careful and assess the end use of funds, the financial health of the entity providing the security interest, etc.

However, the Court interpretation made the role and ambit of financial creditor very clear as in, beyond the act to be a financial creditor, lender has to own a financial debt over corporate debtor.

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