avoidance actions under ibc

I. Introduction

The avoidance transactions regime under the Insolvency and Bankruptcy Code, 2016 (IBC) provides insolvency professionals (IPs) with a powerful tool for recovery of value lost by the debtor’s estate, due to suspect transactions undertaken by the debtor in the vicinity of insolvency. This includes, for instance, transactions where promoters transfer company assets to family members/group companies to shield them from creditors, or pay off debts owed to creditors who are key to the group’s business. In practice however, IPs have had little success in clawing back value lost to avoidance transactions. As of 31-12-2023, IPs have filed 846 applications with National Company Law Tribunal (NCLT), seeking avoidance of transactions involving approximately INR 2.8 lakh crore.1 Of these, NCLTs have only dealt with 143 applications and clawed back a meagre INR 5000 crore – about 1.8% of the total amounts involved2. Thus, even though IPs have reported a staggering volume of avoidance transactions, bottlenecks in adjudication of cases have left these recoveries trapped.

The delay and uncertainty in adjudication of avoidance Transactions is causing serious prejudice to creditors. First, the debtor’s estate loses out on the incremental value that the assets underlying suspect transactions could have contributed in the resolution process. Clawback of assets like land, key machinery and even cash can improve the debtor’s prospects of resolution and the overall recovery for creditors. Second, creditors also face the risk that while avoidance applications are languishing in NCLTs, the assets deteriorate in quality or suffer some other adverse effect, reducing the value recovered by creditors when the matter is finally adjudicated. Third, the prolonged adjudication of these matters including the multiple levels of appeals also translates to increased costs, time and effort for IPs and creditors. This is likely to disincentivise stakeholders from pouring resources to pursue these actions, especially as finality of outcome appears distant and uncertain. Fourth, creditors are presently recovering, on average, a fraction of their claims in both Corporate Insolvency Resolution Process (CIRP) and liquidation proceedings3. If avoidance applications are dealt swiftly, they can be an important avenue to improve recoveries for creditors, especially where high-value assets are involved. A quick and effective mechanism to deal with avoidance applications is thus, a critical missing piece in the current framework of the IBC. In this article, we consider the underlying causes for delay in adjudication of avoidance applications and evaluate whether the introduction of a settlement mechanism can provide a viable alternative framework for dealing with avoidance applications.

II. Challenges in adjudication of avoidance actions

IPs face a difficult uphill battle in bringing a successful avoidance action. We discuss three key challenges below:

(a) Meeting the evidential burden of proof

As the Delhi High Court noted in Tata Steel BSL Ltd. v. Venus Recruiter (P) Ltd.,4 adjudication of avoidance applications by its very nature is a time-consuming and cumbersome process. The first challenge is meeting the evidentiary requirements that are associated with the adjudication of avoidance actions. The IBC requires IPs to undertake a “volumetric as also gravimetric analysis”5 of transactions undertaken by the corporate debtor prior to insolvency, to identify and report to the adjudicating authority any transactions falling within the scope of the avoidance provisions set out under Sections 4351 of the IBC. Thereafter, the adjudicating authority needs to be satisfied that the transaction fulfils the various statutory limbs prescribed for the requisite avoidance action and that it does not fall within any of the statutory exceptions. For instance, to set aside a transaction involving payment of dues to a key operational creditor, the IP will have to establish, inter alia, that:

(i) the transaction placed the creditor in a more beneficial position than it would have been if the debtor’s assets were liquidated and distributed per Section 53 of the IBC; and

(ii) the transaction was not in the ordinary course of business. Such adjudication involves mixed questions of law and fact, and requires NCLTs to undertake an extensive examination of facts rather than make objective determinations.6

Further since each avoidance action brought under the IBC must be adjudicated to finality, IPs need to gather evidence and build a strong case – one that can withstand scrutiny from the adjudicating authority and typically, a prolonged litigation battle with the respondents. This is a challenging endeavour for IPs, made even more difficult, as Indian debtors lack proper maintenance of books of accounts and records.7 An empirical study involving 1189 companies undergoing CIRP under the IBC found that 80% of corporate debtors did not maintain proper books of accounts and lacked adequate documentation models.8 This suggests that in at least some avoidance actions that have merit, IPs are likely to face difficulty in producing requisite evidence to prove that the suspect transactions should be avoided. Where the inadequacy of information is coupled with lack of cooperation from promoters, directors and key employees of the debtor, IPs will find it even more challenging to gather sufficient evidence and build a compelling case. Although Section 19(2) of the IBC empowers IPs to obtain orders from the adjudicating authority directing the debtor’s employees to cooperate. Empirical data suggests that IPs rarely opt for this route.9 Further in some cases where IPs have proceeded to file Section 19 applications seeking assistance from the adjudicating authority, these applications are also languishing in the NCLTs. In other cases where the adjudicating authority has passed requisite orders, directors of the debtor have resigned or refused to cooperate.10 Considerable evidentiary challenges in proving avoidance actions thus persist. Further complexities are introduced in the adjudication of these actions, if forensic audit reports identify multiple transactions as being potentially subject to avoidance. The avoidance litigation will then involve multiple parties, with the IP having to gather evidence and prove its case for each transaction. Moreover, where the application seeks to unwind transactions undertaken with promoters or related parties of the debtor, such applications are likely to be heavily contested.11 In some cases, respondents may deploy “wrecking tactics”,12 such as disputing established facts, filing multiple levels of appeals or filing vexatious applications. The adjudication of avoidance applications to finality can therefore take considerable time and money.

(b) Delays in adjudication

The IBC prescribes a timeline of 330 days and one year for completion of the CIRP and liquidation process respectively. In practice, NCLTs have not managed to keep up with these prescriptive timelines. The latest data published by the Insolvency and Bankruptcy Board of India (IBBI) notes that, as of between April 2022 and December 2022, the average time for completion of CIRP is 813 days in case of resolution of the debtor and 626 days in case of liquidation, whereas for the liquidation process it is 905 days.13 There are several reasons for these delays, including: (i) delays in adjudication of matters by NCLTs, particularly at admission and plan approval stage; (ii) excessive litigation by multiple stakeholders typically involving multiple levels of appeals; and (iii) inadequate Judge strength to deal with the increasing volume of cases. In addition, NCLTs are also facing a severe backlog of cases, with data suggesting that as of 31 -3- 2022, NCLTs were facing a pending caseload of 21,089 cases.14

These statistics spell a grim future for avoidance applications. The IBC does not provide any prescriptive timelines for dealing with avoidance actions – which could have incentivised tribunals to take up these matters with some vigour. To the contrary, it considers avoidance applications to be separate from and independent of the CIRP15 and liquidation proceedings16. Thus, while NCLTs find themselves hard pressed to conclude CIRP and liquidation proceedings within the tight timelines under IBC, avoidance applications have been relegated to the margins of insolvency matters. The fact that 83% of avoidance applications filed since the inception of the IBC are yet to be adjudicated supports this view and reaffirms the need to introduce an alternative framework for dealing with avoidance applications quickly and efficiently.

(c) Lack of funding

One of the most significant barriers to the pursuit of avoidance actions globally has been the lack of funding avenues to pursue these claims.17 In India as well, a company admitted into CIRP is likely to be facing a liquidity crisis. Any funds available in its internal corpus and any interim finance raised from members of the Committee of Creditors (CoC) or other third parties, will first be applied towards meeting the costs of the CIRP and maintaining the debtor as a going concern.

Liquidity concerns apart, creditors may also be wary of disbursing funds to pursue avoidance actions due to the uncertainty in adjudication timelines and quantum of recoveries, risk of excessive litigation and potential enforcement issues, once a successful decision is obtained. These difficulties translate to increased litigation costs for creditors. In some circumstances, the cost of litigation may make the creditors worse off than if they had not pursued the avoidance application at all.18 This is because the costs incurred in pursuing avoidance applications, including for conduct of forensic audits, collation of evidence and the lawyers’ legal fees will usually be paid from the corpus of interim finance raised by the Resolution Professional Payments towards interim finance are however regarded as “insolvency resolution process costs” and are paid in full, in priority to distribution to any other creditors in CIRP.19 If the costs incurred in pursuing avoidance applications exceed the value of assets recovered, creditors will suffer a net loss. The current regime. thus leaves cash-strapped creditors with good reason to pour limited financial resources to pursue avoidance actions.

III. Looking to a settlement mechanism

The discussion above highlights that the adjudication of avoidance actions to finality, as required under the current IBC framework is a costly, lengthy, unpredictable and fact-intensive exercise. Instead, a mechanism allowing for settlement of avoidance actions between the IP (acting on the instructions of the CoC) and respondents in respect of the avoidance applications will offer a faster and more efficient alternative. First, it will allow creditors to quickly settle the dispute and obtain additional recoveries – thus swelling the debtor’s asset pool. For respondents, a settlement will eliminate the expenses and uncertainties involved in avoidance litigation and allow them to use other leverage they may hold with creditors. They may thus opt to negotiate the matter rather than risk excessive costs and a “worse than expected outcome” in litigation.20 Second, a settlement mechanism offers the debtor a more economical alternative to resolve avoidance actions. This may spur IPs and CoCs to report and pursue avoidance actions with more vigour. Third, if the avoidance action involves a complicated factual matrix, multiple jurisdictions or where the asset in question has exchanged further hands, the legal position or the business solution may not be clear. In such cases, a settlement mechanism can allow creditors the leeway to develop a more tailored solution than would otherwise follow from a formal adjudication. Fourth, an alternative framework will also reduce the severe caseload on NCLT and allow the recoveries trapped in pending applications to be resolved. Notably, several jurisdictions encourage the settlement of avoidance actions, including the UK, France, Spain, Germany and the US. 21 In some cases where parties are unable to settle the claim, parties are directed to mediate.22 Adjudication by courts is a last resort.

Settlement of avoidance applications can thus, minimise the time and costs associated with avoidance actions and improve outcomes for creditors. However, it does not come without risk. First, there is risk that the respondent will obtain a release from the claim in exchange for a promise to pay through a structured settlement payment and thereafter, enter insolvency.23 The IP will be barred from pursuing the original action. This risk may be mitigated by the IP securing the payment obligation. However, the respondent’s insolvency will mean that the security interest could be subject to avoidance as a preferential transaction,24 if the conditions under Section 43 of the IBC are met. The same risk can also carry in case of upfront payment in cash. Second, there is risk that the CoC, particularly where it is controlled by a few creditors, approves a settlement that is favourable to them and results in unfair treatment of other creditors.25 US bankruptcy law deals with this issue, requiring that a settlement in respect of avoidance claims be mandatorily approved by the bankruptcy court after deciding that the settlement is “fair, reasonable and in the best interest of the estate”.26 This ensures that the proposed settlement meets a fair and equitable standard.27 If considered necessary and in the absence of a code of conduct for the CoC, the IBC can also mandate that settlements in respect of avoidance applications obtain the blessing of the NCLT. This will ensure fair dealing by the CoC. Third, fraudulent transactions under Section 66 of the IBC as well as avoidance transactions involving elements of criminal action should not be allowed to be settled – these need to be formally adjudicated and where required, appropriate investigative agencies and regulatory authorities will need to be involved.

Given the lamentable treatment of avoidance claims under the IBC, there is a critical need to address the deficiencies in the current avoidance transactions regime. The introduction of a settlement can prove to be one key avenue to speed up the disposal of these applications and deserves careful consideration.

† Partner, Shardul Amarchand Mangaldas & Co.

†† Partner, Shardul Amarchand Mangaldas & Co.

††† Senior Associate, Shardul Amarchand Mangaldas & Co.

1. IBBI, Quarterly Newsletter for October-December 2022, 17.

2. IBBI, Quarterly Newsletter for October-December 2022, 17.

3. IBBI, Quarterly Newsletter for October-December 2022, 20.

4. (2023) 1 HCC (Del) 301

5. Jaypee Infratech Ltd. Interim Resolution v. Axis Bank Ltd., (2020) 8 SCC 401; Ministry of Corporate Affairs, Report of the Insolvency Law Committee (May 2022) 26.

6. (2023) 1 HCC (Del) 301

7. IBBI, Consultation paper on issues related to reducing delays in CIRP (April 2022) 1 3. Available at: https://ibbi.gov.in/uploads/whatsnew/72a560ce5697bbaeef62ce5893a3f1ad.pdf

8. Neeti Shikha and Urvashi Shahi, Assessment of Corporate Insolvency and Resolution Timeline (IBBI Research Initiative 2021) 6.

9. Neeti Shikha and Urvashi Shahi, Assessment of Corporate Insolvency and Resolution Timeline (IBBI Research Initiative 2021) 6. Research found that only 3% of IPs in a survey of 431 IPs had approached the adjudicating authority for directions

10. See for example, Vikram Puri v. Universal Buildwell (P) Ltd., 2022 SCC OnLine NCLAT 306; K. Parameswaran Nair, RP, Samson and Sons Builders and Developers (P) Ltd. v. Jacob Samson CP(IB)/05/KOB/2021.

11. (2023) 1 HCC (Del) 301

12. Vanessa Finch and David Milman, Corporate Insolvency Law: Perspectives and Principles (3rd Edn., Cambridge University Press, 2017) p. 473.

13. IBBI, Quarterly Newsletter for October-December 2022

14. Business Today Desk, “Taking all Necessary Steps to Augment Capacity of NCLT: Govt.” Business Today (21 -3- 2022) <www.businesstoday.in/latest/economy/story/taking-all-necessary-steps-to-augment-capacity-of-nclt-govt-326689-2022-03-21>.

15. Insolvency and Bankruptcy Code, 2016, S. 26.

16. IBBI (Liquidation Process) Regulations, 2016, Regn. 44(1).

17. United Nations Commission on International Trade Law, Legislative Guide on Insolvency Law (2005) p. 148.

18. Aurelio Gurrea-Martínez, “The Avoidance of Pre-Bankruptcy Transactions: An Economic and Comparative Approach”, International Insolvency Institute (2017), 11

19. Insolvency and Bankruptcy Code, 2016, S. 5(13) read with S. 30(2)(a).

20. Jonathan Molot, “Litigation Finance: A Market Solution to a Procedural Problem” (2010) 99 Geo LJ 83.

21. Jonathan Molot, “Litigation Finance: A Market Solution to a Procedural Problem” (2010) 99 Geo LJ 83, 135-137; Suzzanne Uhland and others, Insolvency Litigation Guide (Lexology, 2021) pp. 65- 67.

22. Jonathan Molot, “Litigation Finance: A Market Solution to a Procedural Problem” (2010) 99 Geo LJ 83, 135-137; Suzzanne Uhland and others, Insolvency Litigation Guide, pp. 65- 67.

23. Ira L. Herman, Settlement Agreements in Bankruptcy.

24. Id.

25. Ira L. Herman, Settlement Agreements in Bankruptcy (LexisNexis, 2020) American Bankruptcy Institute, Settlement of Avoidance Actions in Bankruptcy (NYU School of Law 2013).

26. Federal Rules of Bankruptcy Procedure, R. 9019

27. Ira L. Herman, Settlement Agreements in Bankruptcy.

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