Preference and the Exclusion of Transfers Made in the “Ordinary Course of Business” Under the Insolvency and Bankruptcy Code, 2016

PREFACE

One of the important facet of an effective insolvency regime is often dependent on its ability to recover assets transferred for nil or reduced payments in the contemplation of the company’s impending insolvency. It is important that an insolvency regime provides for the avoidance or invalidation of such transfers of assets or properties, or interest thereof as these have the effect of putting the transferee in a better position than the one the transferee would have occupied if such transfer had not been made. These transfers disturb the principle of pari passu distribution of assets of the company undergoing insolvency and are “vulnerable” and “voidable” as they benefit select recipients to the disadvantage of the general body of creditors.¹ By providing for the avoidance of such transfers, the insolvency regime effectively can look back in time and can challenge such transfers for the recovery of monies or properties involved.

Historically, the most commonly used form of avoidance action is in respect of transfers made by the company undergoing insolvency in favour of one or some of its creditors/third parties before the commencement of insolvency proceedings.² Such transfers, which are known as “preferences”, have the effect of conferring a particular creditor(s) more than what other creditors would have received as part of the insolvency resolution process. In India, the Insolvency and Bankruptcy Code, 2016 (“the Code”) allows a resolution professional or liquidator to go back in time to have such transfers/transactions questioned and to bring back the assets into the insolvency process. In this context, the resolution professional is empowered under Sections 43 to 51 and Sections 66 and 67 of the Code to apply for such orders as the adjudicating authority thinks fit for restoring the position to what it had been prior to such transfers/transactions. Under Sections 43 and 44, the Code allows the resolution professional or liquidator to challenge such preferential transfers/transactions that confer particular creditors of the corporate debtor a material advantage in relation to its other creditors. The Code, in sub-section (3) of Section 43, also exempts certain transactions involving the corporate debtor from the purview of avoidance. One such exemption involves “transfer made in the ordinary course of business or financial affairs of the corporate debtor or the transferee.”³ This article seeks to discuss the law relating to avoidance of preferential transactions under the Indian insolvency regime and to shed light on the history and purpose of the exclusion available under sub-section (3)(a) of Section 43 of the Code.

HISTORY OF THE LAW RELATING TO PREFERENCE

The very first case that laid down the foundations of the law relating to the avoidance of preferential transactions is the judgment of Lord Mansfield, C.J. in Alderson v. Temple⁴, which involved an action initiated by the assignees of the bankrupt under the Fraudulent Conveyances Act, 1571. In that case, one day prior to being declared as bankrupt, Alderson had posted a £600 note to one of his creditors, Temple, consisting of two £300 notes. While Alderson committed the acts of bankruptcy on Saturday, the two £300 notes arrived on Monday. In an action seeking the value of notes, the assignees of Alderson inter alia claimed that the transaction in question amounted to an unlawful preference. Lord Mansfield, C.J., while holding that the actions in question were void, noted the transactions that were intended to disrupt the equality of creditors of bankruptcy and that which were not in the ordinary course of business amounted to fraudulent preferences even though the enactment itself did not have a specific provision for avoiding preferential transactions. He observed: (ER p. 385)

… All acts to defraud creditors, or to defraud the public law of the land, as the Statutes of Bankruptcy are, are absolutely void. It has been determined, that a conveyance of all a man’s property in trade to pay a bona fide creditor of the most meritorious nature, though not amounting to half the debt, is fraudulent. Why? Because it is not an act in the ordinary course of business, and must inevitably produce an act of bankruptcy, and it defeats the equality intended by the law. … If the conveyance be to distribute all his effects just as the Statutes of Bankruptcy direct, it is fraudulent and void; because a man shall not choose his own assignees, and thereby defraud the law, which vests the power over bankrupts in the Great Seal. A general question has been started, whether a man may or may not, at the eve of a bankruptcy, give a preference to a particular creditor? I think he may, and he may not. If one demands it first, or sues him, or threatens him, without fraud, the preference is good.

(emphasis supplied)

The principle enunciated in the above judgment has come to be known as the “old rule”, which in its purpose invalidated a fraudulent preference on the ground that if it were permitted to stand “the policy of the bankrupt laws would be defeated”.⁵

Curiously, the first statute to specifically deal with the avoidance of preferential transactions in the UK was the Joint Stock Companies Act, 1856,⁶ which also, for the first time, proclaimed the right of every citizen to have freedom of contract and with it obtain limited liability for operating a business.⁷ Section 76 of the Joint Stock Companies Act, 1856 dealt with companies in the same manner as any other bankrupts and provided that, in the event of winding up of a company, a conveyance, transfer, mortgage, delivery of goods, payment or other act in relation to property would be deemed to be a fraudulent or undue preference and would be invalid if done by or against the company. This was followed by the Companies Act, 1862, which removed companies from the regime applicable to individuals in their bankruptcy. The provisions relating to the avoidance of preferential transactions remained relatively unchanged in subsequent enactments dealing with the regulation of companies until the introduction of the Insolvency Act, 1986.⁸

In India, in relation to the corporate personalities, the concept of “fraudulent preference”, as the Supreme Court noted in its judgment in Jaypee Infratech Ltd. Interim Resolution Professional v. Axis Bank Ltd.⁹ (“Anuj Jain”), was earlier embodied in Section 531 of the Companies Act, 1956 and later introduced in its modified form in Sections 328 and 329 of the Companies Act, 2013. To establish fraudulent preference under Section 531 of the Companies Act, 1956, it was not enough to show that preference was shown to a particular creditor; it must also be shown that it was done “with a view” to give him favoured treatment. The dominant motive attending the transaction had to be ascertained and if it was tainted with an element of dishonesty, questions of fraud arose. Since the inference relates to dishonesty or something approaching close to dishonesty, there must be solid grounds for drawing it.¹⁰ For instance, in Maruti Ltd. v. Laxmi Steel Traders¹¹, goods were returned by the company to the supplier who was pressurising the company for payment. The Court held that this was not a preference but an act of good management on the part of the company inasmuch as it reduced its further liabilities by not keeping the goods for which it could not pay.

Section 328 of the Companies Act, 2013 contains provisions dealing with preferential transactions entered into prior to the order to wind up the company. As regards transfer of property, it is provided in sub-section (2) of Section 328 that if the transaction is made six months before winding-up application, the Tribunal may declare such transaction invalid and restore the position. The provisions relating to winding up of a company due to its inability to pay its debts has since been replaced by the Code. Under the Code, the provisions of Sections 43 and 44 empower the Adjudicating Authority to pass such orders as to reverse the effect of an offending preferential transactions.

PURPOSE OF SECTION 43 OF THE CODE

The purpose of the provisions regarding preference, according to the judgment of the US Supreme Court in Union Bank v. Wolas¹², is twofold: (SCC OnLine US SC)

… First, by permitting the trustee to avoid pre-bankruptcy transfers that occur within a short period before bankruptcy, creditors are discouraged from racing to the courthouse to dismember the debtor during his slide into bankruptcy. The protection thus afforded the debtor often enables him to work his way out of a difficult financial situation through cooperation with all of his creditors. Second, and more important, the preference provisions facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor. Any creditor that received a greater payment than others of his class is required to disgorge so that all may share equally. The operation of the preference section to deter “the race of diligence” of creditors to dismember the debtor before bankruptcy furthers the second goal of the preference section — that of equality of distribution.

Thus, the primary objectives of a statutory provision in relation to the avoidance of preferential transactions is that of securing equality of distribution among similarly placed creditors and deterring the so-called “race of diligence”. These, in turn, enhance the prospect of increasing the amount available for distribution and at the same time reduces the discriminatory risk to creditors.¹³ In that sense, a provision relating to preference is in the nature of a corollary to the other sections as the same is, by its very nature, directed at ensuring that the liquidation of a company is prevented or disrupted by any conveyance, transfer, charge, payment, obligation or judicial proceeding, occurring within the look-back period provided under the insolvency enactment, which in the case of the Code, as we will see, is a period of two years in the case of a related party and one year in case of others. In other words, the operation of such a provision is to “prevent a payment to anybody who, but for such payment, would share in the administration of the bankrupt’s estate”, that is to say “any person who, at the date of the payment to him, would have had to come in and prove and rank with the other creditors in the bankruptcy”.¹⁴

Under the Code, the provisions of Sections 43 and 44 of the Code empower the Adjudicating Authority to pass such orders as to reverse the effect of an offending preferential transaction. Amongst others, the Adjudicating Authority is empowered to pass orders requiring any property transferred in connection with giving of preference to be vested in the corporate debtor and to release or discharge (wholly or in part) any security interest created by the corporate debtor as part of the transaction held to be preferential. As the Supreme Court in Anuj Jain⁹ noted, the consequences of offending preferential transaction are drastic and practically operate towards annulling the effect of such transaction (SCC p. 446, para 21). On an application under Section 43, if the twin conditions specified in sub-section (2) of Section 43 are satisfied, the transaction would be deemed to be of preference. As per clause (a) of sub-section (2) of Section 43, the transaction i.e. transfer of property or an interest thereof of the corporate debtor, ought to be 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 as per clause (b) thereof, such transfer ought to be of the effect of putting such creditor or surety or guarantor in beneficial position than it would have been in the event of distribution of assets under Section 53. This is similar to sub-section (4) of Section 239 of the Insolvency Act, 1986 (UK), which provides that a company is deemed to have given a preference if a person is one of the company’s creditors or a surety or guarantor for any of the company’s debts or other liabilities, and the company does anything or suffers anything to be done which (in either case) has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position he would have been in if that thing had not been done.

In this regard, it is pertinent to refer to observations in the Report of the Bankruptcy Law Reforms Committee (“BLRC”), which conceptualised the Insolvency and Bankruptcy Code, 2016, in respect of such transactions as under:

Treating recoveries from vulnerable transactions

The Committee discussed the possibility of identifying and recovering from vulnerable transactions. These are transactions that fall within the category of wrongful or fraudulent trading by the entity, or unauthorised use of capital by the management. There are two concepts that are recognised in other jurisdictions under this category of transactions: of fraudulent transfers, and fraudulently preferring a certain creditor or class of creditors. If such transactions are established, then they will be reversed. Assets that were fraudulently transferred will be included as part of the assets in liquidation.

The Committee recommends that all transactions up to a certain period of time prior to the application of the IRP (referred to as “the look-back period”) should be scrutinised for any evidence of such transactions by the relevant Insolvency Professional. The relevant period will be specified in regulations. At any time within the resolution period (or during the liquidation period if the entity is liquidated) the relevant Insolvency Professional is responsible for verifying that reported transactions are valid and central to the running of the business. There should be stricter scrutiny for transactions of fraudulent preference or transfer to related parties, for which the “look-back period” should be specified in regulations to be longer.

(emphasis in original)

DUTY OF INSOLVENCY PROFESSIONAL IN RELATION TO PREFERENTIAL TRANSACTIONS

Under the Code, a resolution professional or liquidator is expected to protect the assets of the corporate debtor against transactions that “dismember” the corporate debtor. He is empowered to look back in time to form an “opinion” as to whether the corporate debtor has given a preference within the “relevant time”, which is a period of two years in the case of a related party any time and one year in case of others.¹⁵ If he is of the opinion that a certain transfer/transaction is preferential in nature, he is duty-bound to apply for an order under Section 44 of the Code.

Upon taking control of the corporate debtor, a resolution professional is duty-bound under Section 20 of the Code to protect and preserve the value of the assets of the corporate debtor. Under Section 25(2)(j) read with Sections 43, 45, 50 and 66 of the Code, he must identify and recover the assets lost in irregular transactions and to file appropriate applications under relevant provisions to challenge such transactions. These are inherent powers of the resolution professional and liquidator, and the Code does not envisage any role of the CoC in irregular transactions. The resolution professional may engage the services of professionals, including forensic auditor, to assist him for this purpose.

Notably, a preferential transaction is voidable but not void ab initio,¹⁶ meaning that the transaction may not be affected until the Adjudicating Authority finds it to be preferential. This would, in other words, mean that the transactions remains unaffected and operative till the time the same is challenged as per the provisions of the Code and a finding is made by the Adjudicating Authority in favour of the resolution professional/liquidator. The insolvency professional appointed, however, has a right to question such transactions by applying to the Adjudicating Authority, as can be seen from Section 43. Pertinently, an insolvency professional may be entitled to claim for the avoidance of a transactions only to the extent of the interests of corporate debtor and its creditors. If such interests are met by transfer of or release of or payment of a certain portion of the transaction under challenge, then the provisions regarding preferences may cease to have effect on the other portions.¹⁷

TRANSACTIONS MADE IN THE ORDINARY COURSE OF BUSINESS OF CORPORATE DEBTOR

Under the scheme of the Code, “a transactions made in the ordinary course of the business or financial affairs of the corporate debtor or transferee” is excluded from the purview of the provisions of Section 43. However, whether a particular transaction or payment was made “in the ordinary course of business of the corporate debtor” is often hard to ascertain. This is especially problematic as it is not clear from the Code itself as to what is an “ordinary course” and as to what amounts to the “business of the corporate debtor” or its “financial affairs”. Moreover, should the Adjudicating Authority enquire only into the ordinary business arrangements between the relevant parties prior to the transaction or payment in question? Or should simultaneous payments to other similarly placed creditors be considered as part of the enquiry? Neither the Code nor the accompanying regulations seem to provide an answer. Fortunately, there are some indications available from the drafting of the Code.

Though the drafting of Sections 43 and 44 of the Code has been substantially influenced by IA, 1986 (UK), unlike the UK Act, which requires that the preference be influenced by “desire to produce”, the Code omits the element of “desire”, thereby rendering several UK rulings irrelevant in the Indian context.¹⁸ Further, the exclusion available to “transactions made in the ordinary course of business” is not available in the UK. The phrase, interestingly, appears to have been borrowed from Section 547(c)(2)(A) of the US Bankruptcy Code, where transfers “made in the ordinary course of business or financial affairs of the debtor and the transferee” do not amount to a preference.¹⁹

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 …”. Thus, the “ordinary course of business” defence requires evidence to prove that the alleged preference was “incurred” in the ordinary course of the businesses or financial affairs of the debtor and creditor, and further proof that the transfer was either made in the ordinary course of the debtor’s and creditor’s business or financial affairs (what has been labelled the “subjective element” of the defence), or made according to ordinary business terms (the “objective element” of the defence).²⁰ A person seeking to raise the affirmative defence available under Section 547(c)(2)(A) i.e. the subjective element is required to establish a “baseline of dealing” between himself and the bankrupt debtor. For determining this baseline, a court may consider the following factors:²¹

(i) the length of time the parties were engaged in the type of dealing at issue;

(ii) whether the amounts of the alleged preferential transfers were larger than prior payments;

(iii) whether the payments were tendered in a manner different from previous payments;

(iv) whether there was any unusual action by either the debtor or the creditor to collect or pay the debt; and

(v) whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition.

The courts considering this defence have also referred to the parties’ payment history during the years prior to the look-back period and the consistency in the timing of the alleged preference payments compared with the timing of payments during the parties’ prior course of dealing before the preference period.²² On the other hand, a person seeking to raise the defence available under Section 547(c)(2)(B) i.e. the objective element is required to prove that the transfers in question were made according to “ordinary business terms”. United States Court of Appeals for the Sixth Circuit, in First Federal of Michigan v. Barrow²³, has held that the ordinary business terms test was based on the debtor’s industry.²⁴

The drafters of the Code, however, have chosen to exclude the objective test and have only incorporated the affirmative defence available under Section 547(c)(2)(A) of the US Bankruptcy Code into Section 43 of the Code. Thus, it can be concluded that the Adjudicating Authority, based on the subjective test, is empowered to enquire into both the ordinary business arrangements between the corporate debtor and the creditor in question as well as the effect of other simultaneous payments on an alleged preference. The Adjudicating Authority, in fact, seems to have adopted a similar mode of enquiry in its judgments in ICICI Bank Ltd. v. Shailendra Ajmera²⁵ (where the Authority relied on the “course of conduct” and practice adopted by the respondent Bank in its dealings with the corporate debtor and compared that with the subsequent deviations which resulted in the preference) and S.V. Ramkumar v. Orchid Pharma Ltd.²⁶ (where the Authority took into account simultaneous payments made to several creditors under the supervision of a Corporate Debt Recovery mechanism as envisaged by a joint lenders forum to hold that the transfers did not amount to preference). Similarly, the Adjudicating Authority, in V. Nagarajan v. Asset Reconstruction Co.(India) Ltd.²⁷, has held that a payment of sale proceeds to Arcil towards repayment of its debt secured by exclusive charge on the subject property was in ordinary course of the financial affairs of the respondent as well as that of the corporate debtor, and therefore, fell under the exception carved out in Section 43(3)(a) of the Code.

The ratio in the above judgments are also in line with the judgment of the Supreme Court in Anuj Jain⁹. In that case, the Supreme Court, in order to construe the meaning and essence of “ordinary course of business” relied on the judgment of the High Court of Australia in Downs Distributing Co. Pty. Ltd. v. Associated Blue Star Stores Pty. Ltd.²⁸ (“Downs Distributing”), which stated the expression “ordinary course of business” to mean a transaction that did not require an investigation of the course pursued in any particular trade or vocation and that it did not refer to what is normal or usual in the business of the debtor or that of the creditor. The High Court of Australia had observed:

The provision does not require that the transaction shall be in the course of any particular trade, vocation or business. It speaks of the course of business in general. But it does suppose that according to the ordinary and common flow of transactions in affairs of business there is a course, an ordinary course. It means that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation.

On the basis of the above observation in Downs Distributing²⁸, the Supreme Court held in Jaypee Infratech Ltd. Interim Resolution professional v. Axis bank Ltd.⁹ that furnishing a security would become a part of the “ordinary course of business” of a particular corporate entity only if it fell in place as part of “the undistinguished common flow of business done” and when the same does not arise out of “any special or particular situation”, even if the act of furnishing securities may be one of normal business practices.²⁹ Noting that the corporate debtor in Anuj Jain⁹ had been promoted as a special purpose vehicle for construction and operation of an expressway and for development of the parcels of land along with the expressway for residential, commercial and other use, the Supreme Court held that the corporate debtor, in its ordinary course of business, could not have routinely mortgaged its assets and/or inventories to secure the debts of its holding company or have created encumbrances over its properties to secure the debts of its holding company.²⁹

Interestingly, the legislature in Australia has chosen to retain the ordinary course of business defence only in bankruptcy proceedings but has avoided the use of the same in the present version of Section 588-FG of the Corporations Act, 2001—which applies to corporate insolvency—due to what has been described as “judicial uncertainty” in the interpretation of the term.³⁰ However, as the Supreme Court, in its judgment in Anuj Jain⁹, has referred to and relied upon Downs Distributing²⁸, an Australian judgment relating to the winding up of a company, in arriving at its interpretation of the term “ordinary course of business”, it may be prudent for us to examine the law as it existed in Australia prior to the said change.

Downs Distributing²⁸ was a case in which the payee was found to be not a payee in good faith. The transaction under challenge was in relation a settlement of a debt between traders by the redelivery of goods sold together with other goods subject to an arrangement that the debtor might again purchase the goods for cash. On an application under Section 95 of the Commonwealth Bankruptcy Act, 1924-1946, which avoided preferences given to creditors by bankrupts within six months of bankruptcy,³¹ both the trial court as well the High Court held that the creditor had reason to suspect the debtor was unable to pay its debts as they became due and that the transaction would give a de facto preference to the creditor over other creditors. In the High Court (Latham, C.J., Rich and Williams, JJ.), Latham, C.J. agreed with the basis on which the trial Judge had decided the case and found it unnecessary to deal with the precise meaning of “in the ordinary course of business”, being of the view that on any approach the transaction did not fall within those words. Rich, J. also was of the view that the appeal should be dismissed, but confined himself to holding that the transaction had not been “in the ordinary course of business.” Rich, J., however, referring to the discussion in Burns v. McFarlane³², observed that Section 95(2) supposes that “according to the ordinary and common flow of transactions in affairs of business, there is a course, an ordinary course”. He went on to note, “that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation”.³³

Subsequent judgments such as Cummins, In re³⁴ found it desirable to apply the view of Rich, J. and have held the correct meaning of the term to mean that “the transaction must fall into place as part of the undistinguished common flow of business done … calling for no remark and arising out of no specialor particular situation”.³⁵ The High Court of Australia has also continually emphasised that the section is concerned with the ordinary course of business generally and not the ordinary course of the business of the parties.³⁶ However, the same does not mean that the normal procedures and practices of the parties’ businesses and the trade in which they operate, as well as the dealings between them, are irrelevant. It has been held that the evidence of such matters is necessary so that the court may consider the payment in question in its factual context.³⁷ In contrast to other decisions, the Court in Cummins, In re³⁴ held that the issues of fairness and absence of indicators of insolvency are not so relevant as a fair transaction may be out of the ordinary course, and vice versa. The last observation of Rich, J. in Downs Distributing²⁸, which has been provided emphasis in the judgment of the Supreme Court in Anuj Jain⁹, however, later became a matter of much debate as the same was “so frequently referred to … has been taken by itself, and as suggesting that anything done differently from usual between creditor and debtor cannot be something done in the ordinary course of business. Such a view is far from the realities of commercial life.”³⁷

It may also be noted that, in the context of personal bankruptcy under Section 122 of the Bankruptcy Act, 1966, the Australian courts have observed that “the transaction must fall into place as part of the undistinguished common flow of business done … calling for no remark and arising out of no special or particular situation.…” so as to be classified as a transaction made in the ordinary course of business.³⁴ While the assessment must be made of business in general rather than the particular businesses of the parties, elements of the history of the dealings between the parties can be considered.³⁸

INTERPRETING SECTION 43(3)(a) OF THE CODE

Unlike Section 547 of the US Bankruptcy Code, which is in relation to transfers “made in the ordinary course of business or financial affairs of the debtor and the transferee”, Section 43(3)(a) of the Code replaces the conjunctive “and” preceding the words “the transferee” with a disjunctive “or”. This gives the impression that the said exclusion under Section 43(3)(a) is available if the impugned transfer is made either in the ordinary course of the business of the corporate debtor or that of the creditor in question. However, as the Mumbai Bench of the Adjudicating Authority in Sumit Binani ResolutionProfessional v. Excello Fin Lea Ltd.³⁹ observed: (SCC OnLine NCLT paras 26 & 28)

26. … It is quite possible, it may be a transfer in its ordinary course of the transferee, because the transferee company or any other person need not be an insolvent, or it might be like any other act in its regular business in its perception. If such is the understanding, transferee’s act of ordinariness will not let any act of the corporate debtor action become avoidable preference. If this “OR” is read as given in the legislation, then it will not uphold the objective of main provision that is avoidance of preference, therefore to uphold the main objective of Section 43, “OR” in between corporate debtor and transferee shall be read as AND as given in US Code.

***

28. … After this interpretation, the transfer made in the ordinary course of the business or financial affairs of the corporate debtor and (or) the transferee, it will become explicit that ordinary course of business or financial affairs in between the corporate debtor and the beneficial creditor will become ordinary course of business, but not ordinary course of business independent of each other can become a case to take out ordinary course of business independent of the corporate debtor as defence.

(emphasis in original)

This issue is now settled in light of the judgment of the Supreme Court in Jaypee Infratech Ltd., Interim Resolution Professional v. Axis Bank Ltd.⁹ In that case the Court held that (SCC p. 482, para 28.5) the contents of clause (a) of sub-section (3) of Section 43 of the Code called for a purposive interpretation so as to ensure that the provision operates in sync with the intention of legislature and achieves the avowed objectives. It held that the expression “or”, appearing as disjunctive between the expressions “corporate debtor” and “transferee”, ought to be read as “and”; so as to be conjunctive of the two expressions i.e. “corporate debtor” and “transferee”.

Thus read, clause (a) of sub-section (3) of Section 43 of the Code shall mean that, for the purposes of sub-section (2), a preference shall not include the transfer made in the ordinary course of the business or financial affairs of the corporate debtor and the transferee.

PRESUMPTION AS TO EXISTENCE OF PREFERENTIAL TRANSACTIONS

Under the Code, once a presumption/opinion has been arrived on the given set of facts by the resolution professional or liquidator, if the transferee takes the defence of ordinary course of transaction, then burden lies upon such transferee to prove that transfer is made in the ordinary course of business (Anuj Jain case⁹, SCC p. 483, para 28.6). It is necessary to notice that as per the charging parts of S. 43 of the Code i.e. sub-sections (4) and (2), a corporate debtor shall be deemed to have given preference at a relevant time if the twin requirements of clauses (a) and (b) of sub-section (2) coupled with the applicable requirements of either clause (a) or clause (b) of sub-section (4), as the case may be, are satisfied (Anuj Jain case⁹, SCC p. 483, para 31). The resolution professional or liquidator need not prove that the transaction under question has not been out of ordinary course of business.

In Anuj Jain⁹, the Supreme Court observed: (SCC pp. 466-67 & 471-72, paras 21 & 23)

21.1. … If twin conditions specified in sub-section (2) of S. 43 of the Code are satisfied, the transaction would be deemed to be of preference. As per clause (a) of sub-section (2) of Section 43 of the Code, the transaction, of transfer of property or an interest thereof of the corporate debtor, ought to be 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 as per clause (b) thereof, such transfer ought to be of the effect of putting such creditor or surety or guarantor in beneficial position than it would have been in the event of distribution of assets under Section 53 of the Code.

***

21.3. … even if a transaction of transfer otherwise answers to and comes within the scope of sub-sections (4) and (2) of Section 43 of the Code, it may yet remain outside the ambit of sub-section (2) because of the exclusion provided in sub-section (3) of Section 43.

***

23. The analysis foregoing leads to the position that in order to find as to whether a transaction, of transfer of property or an interest thereof of the corporate debtor, falls squarely within the ambit of Section 43 of the Code, ordinarily, the following questions shall have to be examined in a given case:

23.1. (i) As to whether such transfer is for the benefit of a creditor or a surety or a guarantor?

23.2. (ii) As to whether such transfer is for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor?

23.3. (iii) As to whether such transfer has the effect of putting such creditor or surety or guarantor in a beneficial position than it would have been in the event of distribution of assets being made in accordance with Section 53?

23.4. (iv) If such transfer had been for the benefit of a related party (other than an employee), as to whether the same was made during the period of two years preceding the insolvency commencement date; and if such transfer had been for the benefit of an unrelated party, as to whether the same was made during the period of one year preceding the insolvency commencement date?

23.5. (v) As to whether such transfer is not an excluded transaction in terms of sub-section (3) of Section 43?

In Anup Kumar v. BDR Builder & Developers (P) Ltd.⁴⁰, the resolution professional had filed applications under Sections 45, 49, 50(5) and 66 for setting aside certain transactions. The resolution professional had argued before the Nclat that the transactions in question were preferential, and the considerations were circle rates of the relevant period. On observing that the resolution professional had failed to show if the transactions were for the benefit of a corporate debtor or if the transaction resulted in putting such creditor in any beneficial position., the Nclat held that Section 43 was not attracted. The Nclat further observed that the corporate debtor was engaged in the real estate business and had entered into the transfers in question in the ordinary course of business on account of the same being done by the corporate debtor who was engaged in the business of developing real estate, the provision under Section 43 was not attracted. Similarly, the Nclat in ICICI Bank Ltd. v. Shailendra Ajmera⁴¹, held that that the transactions in question which related to payments made under a letter of credit were made in the ordinary course of business and therefore could not be termed to be preferential.

NO PRIOR HISTORY OF SIMILAR TRANSACTIONS

The impugned transaction between the parties who have no prior history of similar transactions may still be protected by the ordinary course of business defence as long as the first-time transaction is ordinary in relation to the debtor’s and the creditor’s past practices when dealing with other, similarly situated parties.⁴² The Adjudicating Authority, in Dipti Mehta v. Shivani Amit Dahanukar⁴³, for instance, went into the relationship between the respondent holding company and the corporate debtor and held that the impugned transfer would not be a preference as the same was in the ordinary course of business, adopting the standard industry practice even though there had been no prior transactions between the corporate debtor and the creditor in question.

It is important to keep in mind the operation of S. 43 is in relation to transactions that are preferential in nature and that of Section 43(3)(a) concern transactions that are part of the ordinary course of business of the corporate debtor. Thus, there are two questions to be considered: whether the transaction is part of an ordinary course of business of the corporate debtor; and whether a transaction will be a preference. Whether there is a preference by reference to the requirements of Section 43 will involve looking at the effect of the transaction (and in the case of a running account or an ordinary course of business, the ultimate effect of the transaction). Pertinently, there is nothing in the wordings of the provision as to purpose of the transactions under challenge.

In the US, a first-time transaction is not per se ineligible for protection from avoidance under Section 547(c)(2). A history of dealings between the parties is also not absolutely necessary in every case to support a determination that a transaction between a debtor and alleged preference recipient is ordinary.⁴⁴ The ordinary course of business defence can be established by the terms of the parties’ agreement until that agreement is somehow or other modified by actual performance. In the absence of modifying behaviour, the court can look to the parties’ agreement to determine their ordinary course of business.⁴⁵ In Australia, the Court in Richardson v. Commercial Banking Co. of Sydney Ltd.⁴⁶, has held that where a payment “forms an integral, an inseparable, part of an entire transaction its effect as a preference involves a consideration of the whole transaction”. Similarly, in Airservices Australia v. Ferrier⁴⁷, the Australian High Court set out the rationale and intended operation of this principle [in the context of Section 122 of the Bankruptcy Act, 1966 (Cth)], which the Court referred to as the “doctrine of ultimate effect”. The majority held:

If a payment is part of a wider transaction or a running account between the debtor and the creditor, the purpose for which the payment was made and received will usually determine whether the payment has the effect of giving the creditor a preference, priority or advantage over other creditors. If the sole purpose of the payment is to discharge an existing debt, the effect of the payment is to give the creditor a preference over other creditors unless the debtor is able to pay all of his or her debts as they fall due. But if the purpose of the payment is to induce the creditor to provide further goods or services as well as to discharge an existing indebtedness, the payment will not be a preference unless the payment exceeds the value of the goods or services acquired. In such a case a court, exercising jurisdiction under Section 122 of the Bankruptcy Act, looks to the ultimate effect of the transaction.

PREFERENTIAL TRANSACTION UNDER SECTION 43 VERSUS UNAUTHORISED TRANSACTION UNDER SECTION 14 OF THE CODE

Section 43 is in relation to voidable transactions prior to the initiation of the corporate insolvency resolution process. All the problematic transactions subsequent to the initiation of the resolution process would be covered by moratorium under Section 14 of the Code which restrains any transfer, encumbrance, alienation or disposing off by the corporate debtor of any of its assets or any legal right or beneficial interest. In Bijay Kumar Garodia v. Anadya Properties (P) Ltd.⁴⁸, an appeal was preferred by three creditors of the corporate debtor against an order⁴⁹ of the NCLT directing them to pay back the sum that they had received after the initiation of CIRP. The appellants contended that the order of moratorium was passed on 15-1-2018 but was only notified on 22-1-2018. It was contended that the payment was made without the knowledge of the order. The Nclat, however, dismissed the appeal.

CONCLUSION

Usually, in an application seeking to set aside transactions filed under Sections 43 and 44 of the Code, the insolvency professional is confronted with a situation wherein the corporate debtor, facing financial difficulty, chooses to pay one or a select few of its creditors as these creditors pressurise the corporate debtor to make payments. In other instances, the payments to select creditors may be made unintentionally, for example, because of the disarray in the maintenance of the accounts of the corporate debtor. However, even if the transfers were made unintentionally, the same are liable to be set aside as the intention or desire of the corporate debtor or its creditors are irrelevant for the purposes of Section 43 of the Code. Where a particular transfer/transaction is found to be a preference, the creditor in question is liable to pay back the monies so transferred or to deliver the property received. Thus, the essence of a preference is that the transfer had the effect of giving the creditor a priority or advantage over other creditors.

The wide nature of its definition and purpose makes preference a threat to genuine commercial transactions that the corporate debtor may enter into with its trade creditors for its day-to-day business and affairs. However, the exclusion available under sub-section (3)(a) of Section 43 of the Code provides such trade creditors a potential defence against avoidance actions. Such exclusion also acts as an incentive to such trade creditors to continue trading with the corporate debtor—even if it is in its twilight—and prevents the risk of genuine commercial transactions from being labelled as preferential transactions by the adjudicating authority.