‘Antecedent’ Provisions in the Insolvency and Bankruptcy Code, 2016: An Improvement on its UK Counterpart?

[The following post is contributed by Deep Shah, 3rd Year and Rahul Sibal, 4th  Year , students of NALSAR, Hyderabad.  They can be contacted at shahdeep998@gmail.com and sibbalrahul@gmail.com.

In this post, they undertake a comparative analysis of provisions concerning antecedent transactions under the recently enacted Insolvency and Bankruptcy Code, 2016, vis-à-vis the Insolvency Act, 1986 of the United Kingdom (‘UK’).]

Before the enactment of the Insolvency and Bankruptcy Code, 2016 (the ‘Code’), the insolvency regime in India was governed by the Companies Act 1956 (and subsequently the Companies Act, 2013), the Sick Industrial Companies (Special Provisions) Act, 1985,[1] the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (the SARFAESI Act),[2] the Provincial Insolvency Act, 1920 and the Presidency-Towns Insolvency Act, 1909. Evidently, this resulted in a fragmented and unclear insolvency framework with frequent conflicts among the above stated laws.[3] Unsurprisingly, mounting loans and protracted insolvency proceedings led to calls for a unified insolvency regime that would enable swift and effective bankruptcy resolutions. To this end, the Code was enacted with the intent to consolidate the otherwise fragmented insolvency framework in India.

Interestingly, the Code envisages the regulation of ‘preference’ and ‘undervalued’ transactions for both corporate[4] and individual insolvencies.[5] While the previous insolvency legislation also regulated preference[6] and undervalued transactions,[7] both concepts have undergone significant changes under the Code.[8] Before analysing preference and undervalued transactions (collectively ‘antecedent transactions’) in the specific context of the Code, it becomes necessary to obtain a foundational understanding of these concepts.

In the light of impending corporate insolvency proceedings, corporate managements exhibit a tendency to subordinate the interest of the company, which in turn adversely affects the interests of the creditors. For instance, when companies are on the verge of insolvency, the promoter(s) may seek to transfer company assets to a third entity, at undervalued prices. Since the third entity, is ordinarily a related party, the promoter would be able to retain control over the transferred asset which would otherwise have been distributed to creditors through insolvency proceedings. However, unlike concepts of related party and arm’s length transactions under the company and income tax statutes respectively, the existence of ‘related parties’ is not a pre-requisite for the application of the Code to antecedent transactions. One such scenario would be where the managing director, M makes company X enter into a transaction with an unrelated company Y, wherein X receives significantly less consideration than the benefit received by Y. This results in a net outflow of assets or value from company X to Y. Such dealings could be reversed by provisions in the Code that concern undervalued transactions.

However even transactions that are carried out at fair value could be reversed under the Code. For example, take the case of a company X that is nearing insolvency has assets worth Rs. 1000, and two unsecured creditors A and B, both of whom are owed Rs. 700 each. In case of X’s liquidation, assuming there are no other creditors, both A and B would each obtain Rs. 500 through the sale of X’s assets during the insolvency proceeding in (partial) satisfaction of their claims. However, say, prior to the commencement of insolvency proceedings, company X repays the entire debt of Rs. 700 owed to creditor A. In this case, creditor B would merely receive the remaining Rs. 300 (as opposed to creditor A, who received Rs.700), despite possessing a claim equal to that of A. In such a case, although the transaction was undertaken at fair value,[9] it would still constitute a ‘preference’, since creditor A received more than it would otherwise have received through insolvency proceedings. Therefore, unlike undervalued provisions, transactions undertaken at full and proper value, could also constitute ‘preferences.’

As implicit in the foregoing illustration, provisions that concern antecedent transactions operate on the principle that every creditor belonging to the same class should receive a share proportionate to the debt owed to it, otherwise known as the principle of pari passu. For a more detailed understanding of the principle of pari passu and antecedent transactions, please refer to our earlier post on this Blog.

As noted in that post, the Code has been significantly influenced by the Insolvency Act, 1986 of the UK (‘the UK Act’). Therefore, to gain a better understanding of the operation of the Code, it becomes essential to undertake a comparative analysis of provisions concerning antecedent transactions under both statutes. An analysis reveals a commonality between the two statutes, both of which involve three elements, two of which are necessary to attract the provisions on antecedent transactions, – the determination of whether the debtor had a ‘desire’[10] to prefer the opposite party in the transaction in question and the factum of whether the concerned transaction directly ‘triggered’ the insolvency. The third element is the existence of exceptions, if any. It is important to note that the exception can only be availed where the antecedent transaction is undertaken in the ordinary course of the debtor’s business.

The different combinations in which these elements are present in the two statutes have been outlined below:

The Code

 

Personal Insolvency

Corporate Insolvency

Element

Preference Transactions [Section 165(8)]

Undervalued Transactions [Section 164(6)]

Preference Transactions [Section 43(2)]

Undervalued Transactions [Section 45(2)]

Desire

YES

NO

NO

NO

Triggering of insolvency

YES

YES

NO

NO

Exception

NO

YES

YES

YES

The UK Act

 

Personal Insolvency

Corporate Insolvency

Element

Preference Transactions [Section 340(3)]

Undervalued Transactions [Section 339(3)]

Preference Transactions [Section 239(4)]

Undervalued Transactions [Section 238(4)]

Desire

YES

NO

YES

NO

Triggering of insolvency

YES

YES

YES

YES

Exception

NO

NO

NO

YES

As the table suggests, the two statutes provide different standards for the application of provisions concerning antecedent transactions (‘the antecedent provisions’). For instance, antecedent provisions in the UK Act would come into operation only when the transaction in question has ‘triggered’ the insolvency process. However, no such requirement exists in the Code in cases of corporate insolvency. Similarly, the UK Act, unlike the Code, requires the presence of a ‘desire to prefer’ on the part of corporate debtors in case of preference transactions.

However, the existence of ‘desire’, as enshrined in the UK Act, is difficult to establish, since it requires a subjective determination of the debtor’s state of mind, as opposed to the standard of a reasonable man,[11] or an objective effect-based test followed in other jurisdictions such as Australia.[12] In other words, even if circumstances indicate that a reasonable man would only enter into such a transaction if he had the ‘desire’ to benefit the opposite party, such a finding would be inconclusive for the purpose of determining whether the party in question harboured a desire to prefer. Consistent with this reasoning, English Courts have denied the application of antecedent provisions, despite the transaction in question having conferred benefits to the creditor.[13] In the case of In Re: M C Bacon Ltd, a company nearing insolvency secured loans from a bank on the condition that the debentures creating a charge on the assets of the company would be issued in favour of the bank. On liquidation, the transaction was sought to be set aside on the ground that it constituted a preference transaction. The Court observed:

“Intention is objective, desire is subjective. A man can choose the lesser of two evils without desiring either. It is not, however, sufficient to establish a desire to make the payment or grant the security which it is sought to avoid. There must have been a desire to produce the effect mentioned in the subsection, that is to say, to improve the creditor’s position in the event of an insolvent liquidation. A man is not to be taken as desiring all the necessary consequences of his actions. Some consequences may be of advantage to him and be desired by him; others may not affect him and be matters of indifference to him; while still others may be positively disadvantageous to him and not be desired by him, but be regarded by him as the unavoidable price of obtaining the desired advantages…………  Under the new regime a transaction will not be set aside as a voidable preference unless the company positively wished to improve the creditor’s position in the event of its own insolvent liquidation[14]

                                                                                                (Emphasis Supplied)

Working on this understanding, the Court, on the facts of the case, held that that the company’s decision to undertake transactions that were beneficial to the creditor did not stem from its desire to improve the position of the bank, but rather stemmed from its objective to continue trading operations. Therefore, where transactions are entered into as a response to genuine creditor pressure, and not for the purpose of benefitting the creditor, antecedent provisions of the UK Act, would not be attracted.[15]  Consequently, such decisions would encourage a race among creditors to exert pressure on the corporate debtor for the collection of debts.[16] This would, in turn, create a conflict with the very basis of antecedent provisions – ensuring the collective distribution of assets by avoiding an individual satisfaction of claims.

 Consistent with MC Bacon as discussed above, a similar stance was adopted in In re: Fairway Magazines Ltd.[17] In this case, payments made by the corporate debtor to its director were held to not constitute a preference, on the premise that the intent to undertake a transaction beneficial to the creditor need not necessarily result from a desire to prefer the creditor at the time of insolvency. Interestingly, the pre-requisite of ‘desire’ was held to be unfulfilled, in the present case, despite the existence of a presumption against connected persons.[18]

Predictably, the above noted position has been subject to criticism[19] for creating an unsustainable burden on the liquidator to prove the element of desire.[20] Given that corporate bodies do not have an easily identifiable ‘mind’, the difficulty is further exacerbated in case of corporate insolvencies.[21] For these reasons, the requirement of desire is unlikely to be fulfilled on most occasions. Such a position, coupled with the ‘trigger’ requirement, creates too high a threshold for the antecedent provisions of the UK Act to be attracted, resulting in very few claims for the application of antecedent provisions being successful. Empirical Data on corporate insolvencies in the UK reinforce this conclusion.[22]

In this background, the absence of the pre-requisite of ‘desire’ in the Code is an improvement over the UK Act,  since it would allow a more seamless application of antecedent provisions, and ensure better protection of the principle of pari passu. While it could be argued that expansive antecedent provisions might discourage prospective creditors from financing companies that are on the verge of insolvency, the benefits of an expansive provision far outweigh the costs.[23] For one, in case the pre-requisite of ‘desire’ were to be incorporated, small creditors would be discouraged from lending to companies, given that powerful and more informed creditors could apply ‘genuine creditor pressure’ and exhaust the corporate  debtor’s assets before the onset of insolvency.  Second, strict timelines and the adoption of the creditor-in-possession regime would incentivize creditors to lend despite the existence of expansive antecedent provisions. 

Further, local business conditions should be taken into account at the time of incorporating foreign provisions into Indian statutes. Given the high incidence of corporate frauds in India which have shown no sign of abating, a lower threshold would serve as a deterrent against antecedent transactions that are in derogation of the principle of pari passu. Admittedly, a low threshold would increase the incidence of antecedent transactions being retrospectively annulled and adversely affect the commercial certainty of transactions. However, the Code maintains a delicate balance between the principle of pari passu on one hand, and business confidence on the other by providing for exceptions to the application of antecedent provisions.

Curiously, the requirement of ‘desire to prefer’ has been retained by the Code as far as preference transactions undertaken by ‘individuals’ are concerned. The rationale behind the stipulation of different thresholds for individuals’ vis-à-vis corporate debtors is unclear, as the committee reports do not stipulate any rationale for the different thresholds for individual vis-à-vis corporate debtors. Given that preference provisions in the Code with respect to individual insolvencies are structured in a manner similar to the UK Act, it would interesting to see whether and how Indian courts transplant UK jurisprudence while interpreting the pre-requisite of ‘desire’.

– Deep Shah & Rahul Sibal

[1] Repealed with effect from 1st December 2016.

[2] The SARFAESI Act still remains in force and as such continues to exert some amount of influence on the insolvency process.

[3] For example, see Tata Motors Ltd v Pharmaceutical Products of India (2008) 3 Comp LJ 112 (Bom); NGEF Ltd. v. Chandra Developers Pvt. Ltd. (2005) 127 Comp. Cas. 822 (SC); Madura Coats Ltd. v Modi Rubbers Ltd. AIR 2016 SC 3072. See also, Kristin van Zwieten, “Corporate Rescue in India: The Influence of the Courts” (2015) Journal of Corporate Law Studies 1; Aparna Ravi, “Indian Insolvency Regime in Practice: An Analysis of Insolvency and Debt Recovery Proceedings” (2015) 51 Economic and Political Weekly 46.

[4] See Sections 165(8) and 164(6) of the Code.

[5] See Sections 43(2) and 45(2) of the Code.

[6] The provisions were somewhat different, and referred to the transactions as ‘fraudulent preferences’. See Companies Act, 1956, section 531; Companies Act, 2013, section 328; Provincial Insolvency Act, 1920, section 54; and Presidency-Towns Insolvency Act, 1909, section 56.

[7] Though not strictly dealing with the concept of undervalued transactions, the provisions titled ‘avoidance of voluntary transfer’ bore some similarities to the concept. See Companies Act, 1956, section 531A; Provincial Insolvency Act, 1920, section 55; and Presidency-Towns Insolvency Act, 1909, section 55.

[8] The change between the antecedent provisions under previous legislation vis-à-vis the Code is beyond the scope of this post and would be analyzed subsequently.

[9] The transaction could be said to be fair value since creditor A was only paid to the extent of the debt owed to it.

[10] The term ‘desire’ has specifically been used in the provisions, as opposed to intention. This is because, while intent may be determined based on objective criteria, desire depends on the subjective state of mind of the debtor.

[11] The difference between desire and intention discussed in note 10 above is premised on the reasonable man standard.

[12] Andrew Keay, “The avoidance of pre-liquidation transactions: an Anglo-Australian comparison” (November 1988) J.B.L, p.548.

[13] See in Re MC Bacon Ltd. [1990] BCLC 324 at 335-36.

[14] In Re MC Bacon Ltd [1990] BCLC 324.

[15] Ibid, p. 5.

[16] Finch, V, 2nd Edition Corporate insolvency law: perspectives and principles. Cambridge University Press, (2009) p.574.

[17] [1992] B.C.C. 924, Ch.D. (Companies Ct).

[18] Connected persons have been defined under Section 249 of the UK Act and Section 4(24) in the Code (referred to as related parties). All transactions with such persons during the relevant period are presumed to be preference transactions, with the burden of rebutting the presumption lying on such person.

[19] Andrew Keay, Preferences in Liquidation Law: A Time for Change’ [1998] 2 CFI LR 198.

[20] Offer, K., ‘Influential Desire and Dominant Intention’ (1990) 3 Insolvency Intelligence, p. 42.

[21] Finch, V, 2nd Edition Corporate insolvency law: perspectives and principles. Cambridge University Press, (2009) p.573

[22] Peter Walton, Insolvency litigation – a case of “if it ain’t broke, don’t fix it”?, Insolvency Intelligence (2015), p.5

[23] John Armour, Vulnerable Transactions in Corporate Insolvency, Bloomsbury Publishing, (2003) p. 135: the UK position is at odds with the principle of equality, as it favours powerful and well informed creditors over weaker ones (because it exempts genuine creditor pressure, and indirectly encourages a race among creditors), p. 136-7; the principle of deterrence on the other hand, requires discouraging creditors from dismembering companies, and the UK Act achieves the opposite of this by encouraging a race among creditors, p.137. While it recommends debtor in possession finance, that is a matter of discussion for a separate post, independent of this issue. 

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  • Dear Sir, The new website is not user-friendly . We can not find the posts by topic. Further, the look of website is very insipid. Please move it to previous platform or make changes into existing platform.

    • @Gaurav Kumar Gupta. Thanks for your feedback. We will be fine-tuning the website as we go along to make it more user-friendly. The posts can now be found by topic – you can click on the menu button on the top right hand side of the Blog.

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