[Saai Sudharsan Sathiyamoorthy is an advocate practising at the Madras High Court and is one of the Chief Specialist Editors of Wadhwa Law Chambers Guide to Insolvency & Bankruptcy Code (2nd edition, 2021). He can be contacted at [email protected]]
One way that the Insolvency & Bankruptcy Code, 2016 (“the Code”) seeks to secure pro rata distribution among similarly placed creditors is by invalidating preferential transactions that disperse valuable assets of the corporate debtor prior to the initiation of insolvency proceedings. While section 43(1) of the Code enables the resolution professional or liquidator to set the clock back and assail preferential transactions, section 43(3) provides for certain exceptions. One such notable exception under section 43(3)(a) is if a transaction involves “transfers made in the ordinary course of business or financial affairs of the corporate debtor or the transferee”, (“Ordinary Course of Business defence” or “OCB defence”). It essentially enables creditors to retain monies received when engaging in normal or ordinary business transactions with the corporate debtor. This article examines the origin of the OCB defence and the principles governing its use.
Need for the OCB defence
The concept of preference is essentially premised on fairness and equity: when a company is on the brink of insolvency, paying off one creditor may be detrimental to the interests of the other creditors as it would result in a diminution of total assets available for distribution to other creditors. The operation of section 43 is to deter what is called ‘the race of diligence’ of creditors to dismember the corporate debtor before insolvency. The prohibition of preferential transactions also furthers another goal – that of equality of distribution. Thus, if a corporate debtor has made preferential payments to unrelated creditors within a period of one year preceding the insolvency commencement date, the resolution professional/liquidator, after his or her appointment, can challenge transfers that have conferred particular creditors of the corporate debtor a material advantage relative to its other creditors.
However, such a wide definition of preference would mean that almost all genuine transactions that the corporate debtor may have entered into with trade creditors becomes susceptible to being labelled as a preferential transaction. The OCB defence provides such trade creditors a defence against any preference actions under section 43 and encourages them to continue trading with the corporate debtor. This exception incentivises creditors to continue engaging with companies that face the threat of insolvency and enables such companies to continue trading—a major objective of the Code. If the creditor is able to prove that the alleged preference was received in the ‘ordinary course of business’, he or she would be permitted to retain the benefit of the transaction.
Decoding Section 43(3)(a) of the Code
While the Code has borrowed heavily from the Insolvency Act, 1986 of the U.K. in incorporating the OCB defence, the drafters of the Code seem to have been inspired by section 547(c)(2)(A) of the U.S. Bankruptcy Code. In England, section 239, which deals with preferential transactions, does not explicitly provide an exception to transactions conducted in the ordinary course of business. Roy Goode, in his seminal work Principles of Corporate Insolvency (5thed. 2018) at p. 672, observes that in the U.K. “…there is no general exception of transaction entered into bona fide by the creditor in the ordinary course of business.” According to him, what is relevant is not the creditor’s good faith but the question whether the company was influenced by a desire to confer an advantage on him. He further states that where the creditor receives a payment in good faith, it will almost invariably be the case that the company makes the payment as a normal part of its business or to protect its own interests, not to favour the creditor to whom payment is made.
On the other hand, the OCB defence under section 43 of the Code is more explicit and, as noted, takes from one of the exceptions available under section 547(c)(2) of the US Bankruptcy Code i.e., section 547(c)(2)(A). Under section 547(c)(2) of the US Bankruptcy Code, a bankruptcy trustee may not seek to avoid a transfer “…to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was— (A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms…”. A common judicial interpretation of section 547(c)(2) is that subsection (A) requires a subjective standard of proof. The subjective element seeks to evaluate the relationship between the creditor and the debtor based on pre-preference transactions between them. The court may even check whether the parties changed their credit arrangement from the pre-preference period to the preference period. However, this does not mean that a creditor who had engaged with the debtor for the first time would then be automatically liable for the lack of such past dealings. The subjective element only establishes a ‘baseline of dealing’ for evaluating pre-preference practices. [Moltech Power Sys., Inc. v. Tooh Dineh Indus., Inc. (In re Moltech Powers Sys., Inc.), 327 B.R. 675, 680 (Bankr. N.D. Fla. 2005)]. The court in Ewald Bros. v. Kraft, Inc. (In re Ewald Bros), 45 B.R. 52 (Bankr. D. Minn. 1984), declared the subjective element to be a “common sense interpretation of the statute”. Courts in general have found no one factor as being determinative in this analysis. Instead, as the court in FBI Wind Down Inc. v. Innovative Delivery Sys. Inc., 581 B.R. 662, 387 (Bankr. D. Del. 2018) observed that a multitude of factors might be taken into consideration including:
- the length of time the parties were engaged in the type of dealing at issue;
- whether the amounts of the alleged preferential transfers were larger than prior payments;
- whether the payments were tendered in a manner different from previous payments;
- whether there was any unusual action by either the debtor or the creditor to collect or pay the debt; and
- whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition.
In addition to this, a person seeking to take refuge under section 547(c)(2)(B) must prove that the transfers in question were made as per “ordinary business terms”.
The drafters of the Code seem to have incorporated only the subjective element under subsection (A) into section 43 of the Code. In fact, the Mumbai Bench of the adjudicating authority in Sumit Binani v. Excello Fin Lea Ltd. (“Sumit Binani”) has observed that the exception under section 43 “is bodily lifted from” section 547(c)(2) of the US Bankruptcy Act. In that case, entities related to promoters of the corporate debtor had extended loans to the corporate debtor, which then repaid the loans within the relevant period contemplated under section 43. When the resolution professional filed applications under section 43 of the Code assailing the transactions, the related parties sought to use the defence under section 43 (3)(a) and contended that the transfers were made in the ordinary course of business of the corporate debtor. The NCLT, while noting that the burden was with the transferee taking the OCB defence to establish the same, held that the payments made by the corporate debtor were ‘preferential transactions’. This judgment was later upheld by the NCLAT in Tirumala Balaji Alloys Pvt. Ltd. v. Sumit Binani.
Thus, once an application under section 43 of the Code is filed before the adjudicating authority and the twin conditions under subsection (2) are satisfied, the burden shift to the person seeking to take refuge under sub-section (3) to prove that transfer is made in the ordinary course of business. As the Supreme Court, in its judgment in Axis Bank Ltd. v. Anuj Jain, observed:
“…the whole of conspectus of sub-section (3) is that only if any transfer is found to have been made by the corporate debtor, either in the ordinary course of its business or financial affairs or in the process of acquiring any enhancement in its value or worth, that might be considered as having been done without any tinge of favour to any person in preference to others and thus, might stand excluded from the purview of being preferential, subject to fulfilment of other requirements of sub-section (3) of Section 43.”
The appellate authority, in fact, seems to have adopted a mode of enquiry similar to one used under section 547(c)(2)(A) of the US Bankruptcy Code in its judgments in ICICI Bank Ltd. v. Shailendra Ajmera where the authority relied on the practices adopted by the respondent bank in its dealings with the corporate debtor and compared that with the alleged deviations to hold that the same had not resulted in a preference. Even though the ultimate burden is on the creditor taking refuge under section 43(3), this method places the initial burden on the person with the best access to relevant material: the resolution professional/liquidator.
In deciding whether to allow the defence, the adjudicating authority must ensure that such invocation is in line with the objective of protecting the interests of similarly placed creditors. Pertinently, when there is a lack of past dealings between the parties, the adjudicating authority must ensure that the business terms of such dealings are compared with the commercial dealings that are similarly placed. While the authorities in India have attempted to settle the uncertainties surrounding the OCB defence, the adjudicating authority must be circumspect in deeming a particular transaction as ‘preferential’ so that it prevents the risk of legitimate commercial transactions being disregarded. This will encourage trade creditors to continue to do business with troubled debtors.
– Saai Sudharsan Sathiyamoorthy