What are avoidance transactions under the IBC?

Under the Insolvency and Bankruptcy Code (IBC), certain transactions that have been carried out during a company’s financial distress or insolvency may be deemed avoidable. These transactions, known as avoidance transactions, are typically designed to protect the interests of creditors by undoing transfers that were made in a manner that may have been prejudicial to the creditors or were made under fraudulent or preferential circumstances. The Insolvency Resolution Professional (IRP), along with the Committee of Creditors (CoC), has the authority to identify and challenge such transactions in order to restore the company’s assets to the insolvency estate, providing a fair distribution to creditors.

Types of Avoidance Transactions Under the IBC

Preferential Transactions (Section 43)

A preferential transaction refers to any transaction made by the corporate debtor in favor of a particular creditor, or a group of creditors, that gives them preferential treatment over other creditors. These transactions are typically avoided if they occurred within a look-back period of one year prior to the insolvency commencement date.

Examples:

• Payments made to a creditor that put them in a better position compared to others.
• Transfer of assets or property to a related party or creditor that favors them over other creditors.
• Any preferential payment or transfer made in the ordinary course of business to a related party that results in unfair advantage to that party.

Undervalued Transactions (Section 45)

An undervalued transaction occurs when the corporate debtor transfers assets at a value lower than their fair market value, and the debtor receives inadequate consideration in return. These transactions are typically seen as an attempt to diminish the estate’s value and can be avoided if made within a look-back period of two years before the insolvency commencement.

Examples:

• Selling assets at a price far below their market value.
• Transferring assets to a related party without receiving anything of equivalent value.
• Gifts or transactions made to favor one party disproportionately over others.

Fraudulent Transactions (Section 66)

A fraudulent transaction refers to any transfer made with the intention to defraud creditors or avoid liabilities. Such transactions are carried out with the knowledge that the debtor company is in financial distress and may not be able to pay its debts. These transactions can be voided if they are made within the look-back period of one year prior to the insolvency commencement.

Examples:

• Transfers made with the intent to hide assets from creditors or avoid repayment.
• Transactions conducted with the intention to defraud or deceive creditors by concealing the debtor’s assets or liabilities.
• Making false representations about the debtor's financial condition or transactions.

Transactions Defrauding Creditors (Section 49)

Under Section 49, if a transaction is entered into by the debtor that defrauds creditors, it can be avoided. This includes situations where assets are transferred to friends or family members at undervalued rates, with the intent of protecting the assets from creditors.

Examples:

• Transferring assets to a relative or close associate with the intent to shield assets from creditors.
• Selling property to a related party at below-market value, with the intention to defraud creditors.

Process for Identifying and Challenging Avoidance Transactions

Role of the Insolvency Resolution Professional (IRP)

The IRP is tasked with investigating the financial transactions of the corporate debtor during the CIRP. The IRP conducts a detailed review of the company's accounts and identifies transactions that could potentially be avoidance transactions under the IBC. This may involve:

• Reviewing financial statements.
• Identifying unusual transactions or payments made to creditors or related parties.
• Conducting forensic audits to spot fraudulent or undervalued transactions.

Involvement of the Committee of Creditors (CoC)

The CoC plays an important role in scrutinizing potential avoidance transactions. If the IRP identifies any such transactions, the CoC must review the findings and decide whether they should be challenged before the National Company Law Tribunal (NCLT). The CoC has the power to:

• Approve or disapprove the avoidance actions proposed by the IRP.
• Initiate legal proceedings before the NCLT for the recovery of assets from these transactions.

Challenging Transactions Before the NCLT

The IRP, with the approval of the CoC, can file an application before the NCLT to challenge the avoidance transactions. The NCLT will then decide whether the transaction is avoidable based on the evidence presented.

The NCLT can:

• Declare the transaction void and reverse the transfer.
• Order the recovery of transferred assets or payments.
• Impose penalties or fines on individuals involved in fraudulent conduct.

Consequences of Avoidance Transactions

Reversal of the Transaction

If the NCLT finds that a transaction is an avoidance transaction, it can order the reversal of the transaction. This means that the asset or payment involved in the transaction will be returned to the company’s estate for the benefit of creditors.

Liability of Directors and Other Parties

Directors and other individuals involved in fraudulent or preferential transactions may be held personally liable for the losses incurred due to the avoidance of these transactions. They could also face penalties under the IBC or other laws like the Companies Act, 2013.

Impact on Creditors

The reversal of avoidance transactions increases the assets available for distribution among creditors, ensuring that all creditors are treated fairly. In case of fraudulent transactions, the creditors who were deprived of their fair share are entitled to recover their dues.

Example of Avoidance Transactions

Example: ABC Ltd.

ABC Ltd. is undergoing CIRP. The IRP investigates the financial transactions made by the company and identifies the following avoidance transactions:

• Preferential Transaction: A payment of ₹50 lakhs was made to a creditor within 3 months before the insolvency process began. The payment was made when the company was already in financial distress and could not pay other creditors. This payment was preferential, as it placed this creditor in a better position than others.
• Undervalued Transaction: The company sold a commercial property worth ₹2 crore to a related party for ₹1 crore. The IRP determines this transaction to be undervalued, as the asset was sold at half its market value.
• Fraudulent Transaction: A transaction was discovered where ABC Ltd. transferred its intellectual property rights to another company controlled by one of the directors at an extremely low price, with the intent to defraud creditors.

The IRP and the CoC agree to challenge these transactions. The NCLT rules that the payment and asset transfers are avoidable, and orders the reversal of the transactions. The director involved is held personally liable for the fraudulent transaction, and the creditors get a larger share of the company’s assets.

Conclusion

Avoidance transactions under the IBC are transactions that, due to their fraudulent, preferential, or undervalued nature, unfairly harm creditors and must be reversed during the Corporate Insolvency Resolution Process (CIRP). The Insolvency Resolution Professional (IRP), with the approval of the Committee of Creditors (CoC), plays a key role in identifying and challenging such transactions to ensure fairness in the distribution of assets during insolvency proceedings. Transactions that are fraudulent or conducted in bad faith can have serious legal consequences for directors and other individuals involved.