Answer By law4u team
Under the Insolvency and Bankruptcy Code (IBC), preferential transactions refer to any transactions made by the debtor company that give preferential treatment to a particular creditor or a group of creditors over others, especially when the company is in financial distress or approaching insolvency. These transactions are subject to review during the Corporate Insolvency Resolution Process (CIRP) to ensure fairness among all creditors. If identified, preferential transactions can be reversed by the Insolvency Resolution Professional (IRP) or the Committee of Creditors (CoC), and the assets may be returned to the company's estate for equitable distribution.
What Are Preferential Transactions?
A preferential transaction is one where a company makes a payment or transfers assets to a creditor or related party, which results in that creditor receiving better treatment than other creditors under the same circumstances. These transactions are typically seen as unfair because they favor certain creditors over others and may harm the overall recovery process for the company's stakeholders.
Preferential transactions are defined under Section 43 of the IBC and include the following situations:
Transfer of Assets or Payments
If a company makes a transfer of assets or payments to a creditor in such a way that the creditor is paid earlier or in a better position compared to others, it is considered a preferential transaction. This can include cash payments, transfer of property, or settlement of debts that are more beneficial to one creditor.
Transactions with Related Parties
Transactions between the debtor company and its related parties (such as directors, shareholders, or entities controlled by the company) that give preferential treatment to those parties are also considered preferential.
Transactions Made During Financial Distress
Preferential transactions often occur when a company is facing financial distress or insolvency. If payments are made or assets are transferred to creditors within a specified period before the insolvency proceedings, it may be presumed that the debtor intended to provide unfair preference to certain creditors.
Conditions for a Transaction to Be Considered Preferential
To be classified as a preferential transaction under Section 43 of the IBC, the following conditions must be met:
Look-back Period
The transaction must have occurred within a look-back period of one year prior to the date on which the insolvency petition was filed against the company. For related parties, the look-back period is extended to two years.
Preference to a Creditor
The transaction must result in a preference to a particular creditor, meaning that the creditor receives a higher payment or better terms than they would have received if the company went through insolvency proceedings.
Financial Distress
The debtor company must be in a state of financial distress or insolvency when the preferential transaction takes place. It should be clear that the company is unable to pay its debts as they become due.
Effect on Other Creditors
The transaction must have a detrimental effect on other creditors. That is, it deprives other creditors of their fair share of the debtor’s estate.
Examples of Preferential Transactions
Early Payment to a Creditor
A company that is nearing insolvency makes a payment of ₹10 lakh to one of its creditors, even though it owes a similar amount to several other creditors. This payment is made within the one-year look-back period and gives that creditor preferential treatment.
Sale of Assets to a Related Party
A company sells its property to a related party at below market value, transferring the asset from the estate of the company to the related party without adequate consideration. This transfer, which occurs within the look-back period, is considered preferential as it favors the related party over other creditors.
Set-off of Debts
A company with multiple creditors may choose to settle a large part of its debt with one particular creditor (even though it owes money to others) just before filing for insolvency. This set-off gives that creditor an advantage over other creditors.
How Are Preferential Transactions Handled During Insolvency?
Role of the Insolvency Resolution Professional (IRP)
The IRP is responsible for reviewing the company's financial transactions and identifying any preferential transactions that may have occurred during the look-back period. If the IRP finds such transactions, they may file an application with the National Company Law Tribunal (NCLT) to reverse the transaction.
Role of the Committee of Creditors (CoC)
Once the IRP identifies a preferential transaction, the CoC is involved in deciding whether to challenge the transaction. If the CoC agrees that the transaction was preferential and detrimental to the interests of creditors, they can take steps to reverse the transaction and ensure fair treatment of all creditors.
Challenge Before the NCLT
The IRP or the CoC may file an application with the NCLT to challenge a preferential transaction. If the NCLT accepts the challenge, it can order the reversal of the transaction and require that the property or payment be returned to the company's estate.
Reversal and Restoration of Assets
If the NCLT finds that a transaction was preferential, it will reverse the transaction and restore the assets or payments to the company's estate. This helps to ensure that all creditors receive their due share of the assets during the insolvency proceedings.
Consequences of Preferential Transactions
Reversal of Transaction
The primary consequence of a preferential transaction is that it can be reversed. The transfer or payment made to the creditor is returned to the company’s estate for the fair distribution among all creditors.
Liability of Directors and Officers
If the preferential transaction was carried out with the intent to defraud or favor certain creditors unfairly, the directors or officers involved may be held personally liable. They can be penalized under the IBC or the Companies Act, 2013.
Impact on Creditors
The reversal of preferential transactions ensures that all creditors are treated equally in the insolvency proceedings. It prevents discriminatory payments and ensures that no creditor is unfairly favored at the expense of others.
Example of Preferential Transaction
Example: ABC Ltd.
ABC Ltd. is facing insolvency proceedings and has filed for CIRP. During the investigation, the Insolvency Resolution Professional (IRP) identifies the following preferential transactions:
- Payment to a Key Supplier: ABC Ltd. made a payment of ₹50 lakh to a key supplier within 6 months of filing for insolvency. This supplier had been paid more than other creditors, even though ABC Ltd. owed debts to other suppliers as well.
- Sale of Machinery to a Related Party: The company sold a valuable piece of machinery to a related party at 50% of its market value just before the insolvency petition was filed. The machinery was transferred for far less than its actual worth.
The IRP and the Committee of Creditors (CoC) agree to challenge these transactions as preferential. The NCLT rules that both transactions were preferential and orders the reversal of the payments and asset transfer. The payments and machinery are restored to the company's estate for equitable distribution among all creditors.
Conclusion
Preferential transactions under the Insolvency and Bankruptcy Code (IBC) are those that provide an unfair advantage to certain creditors over others during the period leading up to insolvency. These transactions can be challenged and reversed during the Corporate Insolvency Resolution Process (CIRP) if they meet the criteria defined in Section 43 of the IBC. The goal is to ensure fairness and equitable treatment of all creditors and prevent companies from using their distress to favor specific creditors.
