- Dr Raghav Pandey*
This piece looks to explain the law in India concerning the avoidance transactions, its economic rationale and critically explores the jurisprudence as evolved through recent judgments of the courts.
With the enactment of the Insolvency and Bankruptcy Code, 2016 (IBC), the concept of avoidance transactions has been introduced by the policymakers, keeping in line with the global best practices in the realm of insolvency law. Under the scheme of the IBC, a class of transactions can be avoided or undone by the resolution professional (RP) or the liquidator in charge of the management of the company during the resolution process or the liquidation process, respectively, by making an application to the Adjudicating Authority. This piece looks to explain the law in India concerning the avoidance transactions, its economic rationale and critically explores the jurisprudence as evolved through recent judgments of the courts.
This class of transactions comprises of preferential, undervalued, fraudulent and extortionate transactions. These are dealt with under Sections 43-51 of the IBC. Even though each transaction is of a different nature, the impact of any of the above is the same as they deplete the assets of the corporate debtor. To get a perspective on how much value may be locked in transactions of these types, the records released by the IBBI show that a total of Rs 2.2 lakh crores worth of 786 applications for avoidance transactions have been received by the adjudicating authority as of June 2022.
We can understand the impact through a simple example of an undervalued transaction. If a company X is under insolvency, it generally will have several creditors whose dues would be pending against X. The promoter of X, just before the commencement of the insolvency proceedings, may sell certain assets of X at a price lower than its actual value. For instance, it can be a piece of real estate property which is valued at Rs 1 crore owned by X, but the promoter may sell it for Rs 1 lakh, and it is sold to someone either related or known to the promoter. The effect of this transaction is that the creditors who loaned money to X for it to purchase the real estate, in the first place, are left with just Rs 1 lakh to distribute among themselves. In an ideal scenario, Rs 1 crore should have been realised by the creditors. To negative the effect of such transactions, the RP or the liquidator may file an application with the adjudicating authority, which can reverse such a transaction.
Unfortunately, the disposal rate of such avoidance applications is abysmally low. Out of the total 786 applications received, only 86 have been disposed of. Commensurately, out of the total Rs. 2.2 lakh crore worth of value in dispute; only matters worth Rs 17846 crores have been adjudicated upon. Even worse is the fact that a value worth just Rs 59.64 crores has been clawed back as of June 2022. Thus, there is a problem that has arisen in a few cases where the applications for avoidance transactions have been pending with the Adjudicating Authority, and the resolution plan has been approved. This leads to another critical issue as to what happens to the recovery from the transactions that have been avoided?
The question is, should the recovery so made by reversing such transactions, go to the corporate debtor or to the creditors. One may argue that if the original transaction has happened with the corporate debtor, the amount clawed back should also accrue to the corporate debtor, and there should be no confusion on that. However, the problem here is that since the resolution plan has been approved, the corporate debtor is under a new management, which has assumed control by virtue of the passing of the resolution plan. The creditors, at this point, can very reasonably make a point that the recovery from the corporate debtor in its old avatar should go towards the debt that was owed to them and not to the corporate debtor under the new management.
This question first came up before a single judge bench of the Delhi High Court in the case of Venus Recruiters Pvt Ltd. v Union of India and Ors.This case is related to the insolvency resolution of Bhushan Steel. In this case, the application of insolvency against Bhushan Steel was admitted on 26th July 2017. In furtherance to that, on 20th March 2018, the resolution plan by Tata steel was approved by the Committee of Creditors (CoC). This was also approved by the Adjudicating Authority on 15th May 2018. However, during this intervening period, on 9th April 2018, the RP filed an avoidance application. This delay was on account of a forensic audit report which had come only then. Now the question before the Court was to whom the recovery from such an avoidance application should go. The creditors or the corporate debtor under new management? The Delhi High Court ruled:
An avoidance application for any preferential transaction is meant to give some benefit to the creditors of the Corporate Debtor. The benefit is not meant for the Corporate Debtor in its new avatar, after the approval of the Resolution Plan. This is clear from a perusal of Section 44 of the IBC, which sets out the kind of orders which can be passed by the NCLT in case of preferential transactions. The benefit of these orders would be for the Corporate Debtor, prior to approval of the Resolution Plan. Any property transferred or sum acquired in an order passed in respect of a preferential transaction would have to form part of the final Resolution Plan. The Resolution Plan would have to take into consideration such amounts and benefits which can be given to the Corporate Debtor for the benefit of the CoC. The benefit of an avoidance application is not meant for the company, after the Resolution Plan is considered by the CoC and approved by the NCLT.
The Court here made it clear that any benefit from insolvency proceedings is meant for the creditors. Accordingly, the new management can't take any benefit deriving from the avoidance applications. This was a particularly unique case, where the avoidance application was itself filed very late, which is not something which will happen in most cases. The Court, in fact, has criticised this approach that the RP may continue indefinitely to file applications of this sort. Though the decision was challenged before a division bench of the High Court, where the court reversed its finding with respect to two other questions, it still upheld that the clawed back amount should go to the creditors.
The effect of this judgment was that the resolution applicants from hereon started mentioning a clause in the resolution plan itself, which provided that any benefit from any pending avoidance applications would accrue to the corporate debtor under the new management. The logic herein is also sound enough. Suppose a probable sum of Rs Y is expected to be recovered from the pending avoidance applications. The resolution applicant, in its resolution plan, mentions that Rs Y will accrue to them in the event of any recovery. When the CoC votes for the approval of the plan, it is cognizant of the fact that the bid value of the resolution applicant has adjusted for a sum of Y. If the bid value is Rs Z, the actual value of the corporate debtor may be Rs W, where Z=Y+W. Thus, the resolution applicant may be offering more money in the resolution plan in anticipation of the supposed recoveries from avoidance applications which may be pending at that time. Whether the sums have been accounted for or not then becomes a commercial question that the CoC is empowered to make. If it finds that Z contains Y, then it may approve the resolution plan or reject it if found otherwise. Moreover, the resolution applicant, while incorporating such a clause, also accounts for a risk that the sum Y may not accrue to it at all.
The problem in Venus was that since the applications were filed after the CoC had approved the resolution plan, there was no way the resolution applicant could have accounted for the value of those. Thus, the judgement didn't cover a situation where the resolution plan has a provision about the fate of the avoidance applications. This question came up before the NCLAT in the case of 63 Moons Technologies Ltd. v Dewan Housing Finance Ltd. Herein, the plan contained a provision to the effect that the recoveries would accrue to the resolution applicant. The plan was approved by an overwhelming majority of 98.94% of the members of the CoC, which included the creditor who made the application before the court as well. It is also interesting to note that the initial Request For Resolution Plan (RFRP) contained a provision that any recoveries from the avoidance application would pass through to the creditors. The resolution applicants objected to this, and this particular provision was changed to allow the resolution applicants to provide in the resolution plan that the benefit will instead accrue to the corporate debtor under new management.
It is, therefore, clear from the facts that the CoC was well aware of both the possible recoveries and that the resolution applicant wants to claim them and yet they voted in favour of such a plan almost unanimously. The question before the NCLAT was, therefore, if such a provision in the resolution plan was against the law. If it was indeed illegal, then the CoC couldn’t have taken a call on that question at all, for it can only take a call on questions of commercial nature. In the instant case itself, if the provision was against the law, then the resolution couldn’t be approved by the adjudicating authority. The NCLAT ruled:
146. Such positive affirmation by the foreign courts evinces that the creditor of the Corporate Debtor are sole beneficiaries, and some direct benefit must ensure, in their favour. Accordingly, the proceeds may be distributed amongst them in accordance with the waterfall mechanism provided under Section 53(1) of the I & B Code, 2016, unless an alternate one is found by the Adjudicating Authority to be appropriate.
147. Any decision taken by the committee of creditors which strikes at the very heart of the Code cannot simply be upheld under the garb of commercial wisdom. In other words, the COC's decision to approve the resolution plan submitted by Respondent No. 2, which contains unlawful stipulations concerning intelligible bifurcations of recoveries under two similarly placed sets, is unsustained in the eyes of the law. Accordingly, it is illegal, and the plan containing such an illegal stipulation is not sustainable.
Accordingly, the NCLAT set aside the resolution plan on the ground of illegality. The judgment is under challenge before the Supreme Court, and the issue remains unsettled. There are fundamental problems with this judgement. The primary being that the Court has drawn on "affirmations" by the foreign courts. What is interesting to note is that none of the authorities referred by the Court, foreign or otherwise, deal with this issue at all. Firstly, it cited re Centennial Industries, Inc. vs NCR Corporation which is an American case, which only states that the clawed back amount should go to the creditors as a general principle. It doesn’t cover a situation in which the amount will still go to the creditors if they have mutually agreed to do the opposite in the resolution plan. Further, the court cites, Re Greenberg where the primary issue as mentioned in the first line of the decision is:
The issue in this case is whether the primary creditor in the debtor's chapter 7 case may purchase from the trustee an assignment of his rights to pursue all existing or potential avoidance claims…
The court also cites re Vogel Van Storge, Inc.which has also been cited in Greenberg also, where the issue is assignment rights of pursuing an avoidance application. This right is with the trustee in the US and is sought to be assigned to an individual creditor in the case. The entire jurisprudence is alien to the IBC and is not relevant in any sense to the issue in hand.
Similarly, in Re Yegerphone Ltd. where it was decided that any recovery from a wrongly preferred creditor will be distributed amongst all creditors and the amount would not go to the corporate debtor.
It is not clear from the judgement of the Court how the stipulation on the fate of recoveries is wrong in law. Such a provision is not covered by any of the existing provisions of the IBC or any other law. Even if the NCLAT deduced the intent of the IBC, it is not appropriate to set aside a resolution plan solely on that basis. It should have found a clear violation of a legal provision before setting aside the resolution plan.
None of the authorities, especially the foreign authorities cited, dealt with a matter where the resolution plan has been approved, and yet the avoidance applications have been kept pending. This issue is very much sui generis to India because of the extreme pendency in the courts.
The avoidance applications as it is are not statutorily bound by time, as is the resolution process; thus, the courts don't prioritise them. This is a situation that the policymakers and the drafters of the IBC would not have imagined. In the view of the author, if there is a provision in the resolution plan covering the fate of such provisions and possible recoveries, then such a provision should be respected by courts, as it indeed falls in the ambit of commercial wisdom and not otherwise.
The Delhi High Court and the NCLAT have entirely missed another important aspect of this issue. The proceedings with respect to avoidance applications should not be seen in isolation from other proceedings that may be underway during the moratorium period of the resolution process. The moratorium, which is imposed under Section 14 of the IBC, only covers proceedings against the corporate debtor. As for the proceedings for the benefit of the corporate debtor, they can continue. The same has been decided by the Delhi High Court in Power Grid Corporation of India Ltd v. Jyoti Structures Ltd. It is entirely possible that such proceedings outlast the resolution process. Whenever an adjudication happens, and there is a possible benefit to be accrued to the corporate debtor, can the same be passed over to the creditors? In the opinion of the author, the same is not possible because the proceedings, for instance, a suit, will be instituted in the name of the corporate debtor and the benefit will accrue to it only. The interest of the creditors can be safeguarded again by providing for them in terms of the resolution plan, and the CoC can take a call on them. Thus, it can be reasonably argued that on this issue, the judgement of the Adjudicating Authority in 63 Moons contained the correct position under law.
*Dr Raghav Pandey is an Assistant Professor of Law at National Law University Delhi