Preferential Transactions: Potential Interpretations Based On The US Bankruptcy Code

The key challenge going

forward will be for the

NCLT to adopt a purposive

interpretation to the IBC

provisions on preferential

transactions which strikes a

balance between preventing

unfair payments and ensuring

that lenders are willing

to continue supporting a

distressed business during

the time when their support

is most required

A fundamental objective of insolvency law

is ensuring pari passu (on equal footing)

treatment of creditors of the same class. When

borrowers become financially distressed,

individual creditors are incentivized to press

for payment in priority to other creditors to maximize their

individual recovery. Borrowers themselves are incentivized

to prioritize payments to certain lenders (for example, those

who hold a personal guarantee from the promoters of the

borrower). Insolvency legislation in various jurisdictions, for

example, the United States of America ("US") and England,

describes such payments as "preferences" and allows for

insolvency professionals appointed over insolvent debtors

to apply to a Court to set them aside and recover the monies

paid out into the common pool available to all creditors

with unsecured claims in accordance with the legislative

order of priority.

The Insolvency and Bankruptcy Code, 2016 ("IBC")

has introduced provisions prohibiting "preferential

transactions" in Indian insolvency legislation.² Resolution

professionals have a duty to report such transactions to the

committee of creditors and to file applications to set them

aside.³ The US Bankruptcy Code ("US Bankruptcy Code")

has contained similar provisions for a number of years. This

article considers the preferential transaction provisions in the IBC and how these might be interpreted based on the

US Bankruptcy Code and decisions of the US Courts. It also

briefly considers additional defenses available to creditors

in the US, which might be argued in India.

"Preferential Transactions" Provisions in

the IBC

Under the IBC, a liquidator or resolution professional may

apply to the National Company Law Tribunal ("NCLT") to

set aside a transaction made within a "relevant time" if the transaction: (a) is a transfer of property or an interest

thereof of the corporate debtor for the benefit of a creditor

or a surety or a guarantor for or on account of an

antecedent financial debt or operational debt or other

liabilities owed by the corporate

debtor; and (b) has the effect

of putting such creditor or a

surety or a guarantor in a

beneficial position than it

would have been in the event of

liquidation.⁴

The "relevant time" period is: two

years preceding the insolvency

commencement date in the case

of a "related party"; and one year

in the case of any other person.⁵

The term "related party" is

widely defined and includes,

for example; promoters;

directors; key managerial

personnel; entities related to

the aforementioned categories

of persons; "any person on

whose advice, directions or

instructions, a director…

is accustomed to act"; and

"any person associated with

the corporate debtor on account

of: (i) participation in decisionmaking

processes…; (ii) having

more than two directors in

common…; (iii) interchange

of managerial personnel…; or

(iv) provision of essential

technical information to, or from,

the corporate debtor".⁶

These provisions are similar to

the relevant provisions in the US

Bankruptcy Code, which provide

that a trustee in bankruptcy may

apply to set aside "any transfer

of an interest of the debtor in property" which: was made to

or for the benefit of a creditor; was made on account of an

antecedent debt; was made while the debtor was insolvent;

was made within 90 days before the filing of a bankruptcy

petition or within one year if made to an "insider";

and enabled the creditor to receive more than it would

have received in liquidation.⁷ As such, US legislation

and Court decisions may be of assistance in predicting how

the NCLT will interpret certain

terms and adjudicate certain

issues.⁸ In particular, they may

assist with determining the

following:

• Whom the payment must

  be made to - US legislation

  provides that the recipient must

  be an actual creditor.⁹ If a debtor

  transfers property to a person

  to whom it owes nothing, the

  transfer is not a preference but

  could be set aside as a fraudulent

  conveyance.¹⁰ The equivalent

  under the IBC would be an

  application to set aside such a

  payment as a transaction at an

  undervalue.¹¹

• Who can be liable to repay -

  The US Courts have adopted a

  wide interpretation (as appears to

  be the intention under the IBC).¹²

  For example, they have held that

  this could include junior creditors

  who have indirectly benefited

  where a payment to a senior

  creditor increases the value of

  the junior creditor's interest in

  the collateral.¹³

• Who would be considered

  a "related party" – The wide

  definition of related party is

  potentially problematic. For

  example, bank lenders in India

  often hold equity in borrowers

  pursuant to the Reserve Bank

  of India's Strategic Debt

  Restructuring Scheme and could fall within the

  definition as a result. The US Courts have adopted a

  pragmatic approach in similar cases. They have held

  that a lender who has an affiliate with an equity interest in a debtor (a common situation in the case of bank

  lenders) should not be deemed an insider in the absence

  of evidence that the lender used the affiliate to influence

  the debtor's decisions.¹⁴ They have also held that a

  unique relationship with the debtor is not enough to

  support a finding of insider status without additional

  evidence.¹⁵

• When a transfer is deemed to have occurred – The IBC

  does not state when a transfer will be deemed to have

  occurred. This is of some importance in determining

  whether the transfer in question falls within the

  "relevant time" period. By way of comparison, the US

  Bankruptcy Code provides that a transfer is deemed to

  have been made: on the date it occurred if perfected

  within 30 days; on the date it was perfected if this

  was more than 30 days after the transfer occurred; and

  immediately before a bankruptcy petition was filed if

  it was not perfected before bankruptcy.¹⁶ Perfection

  is deemed to have occurred when a transfer is fully

  effective against third parties under the relevant state

  law.¹⁷

Defenses

For the purposes of the IBC, preferences do not include the

following transfers:¹⁸

"(a) a transfer made in the ordinary course of the

business or financial affairs of the corporate debtor or

the transferee;

(b) 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 the 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."

Again, the US Bankruptcy Code contains similar defenses

for creditors.¹⁹ As such, the US Courts' decisions may

provide guidance on the following issues:

• Is "ordinary course of business" to be measured by a

  subjective or objective standard – According to the US

  Courts, it is the subjective standard of what is ordinary

  between the parties.²⁰

• What sort of payments would be within the "ordinary

  course of business" – The US Supreme Court has held

  this includes ordinary repayments of principal and

  interest.²¹ As regards payments made pursuant to a

  restructuring agreement, the US Courts have held that

  this is a question of fact and depends on the nature of

  industry practice.²²

• Does "new value" include a creditor's forbearance

  of its rights – While this is not a settled issue in the

  US, some Courts have held that "new value" does not

  include a creditor's forbearance of its rights.²³


The US also allows creditors the following additional

defenses, which might be argued by creditors in India faced

with preference challenges:

• The "earmarking doctrine" – If a third party provides

  funds (either by way of a payment or a loan) to

  a debtor to repay a specific pre-existing debt, the

  US Courts would generally not treat this as a

  preference if the funds were clearly earmarked for

  this purpose.²⁴ Their reasoning is that the payment

  would not be to the detriment of other creditors

  because the debtor could not have used the funds to

  repay anyone else. The third party must have directed

  the debtor to use the funds to pay the debt, and the

  debtor must have had no control over how it could use

  the funds.

• Subsequent advance of new value – Under the US

  Bankruptcy Code, an unsecured creditor who extends

  further unsecured credit or new value after receiving

  a preferential transfer from a debtor may set this off

  against the preferential payment.²⁵ The purpose of this

  defense is to encourage creditors to continue doing

  business with the borrower while replenishing the

  diminished estate.

Conclusion

The IBC provisions on preferential transactions appear

to have incorporated best practices from different

jurisdictions, including the US. The key challenge

going forward will be for the NCLT to adopt a purposive

interpretation to these provisions which strikes a balance

between preventing unfair payments and ensuring that

lenders are willing to continue supporting a distressed

business during the time when their support is most

required.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.