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February 26, 2018

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Preferential Transactions: Potential Interpretations Based On The US Bankruptcy Code


- James H.M. Sprayregen, Partner [ Kirkland & Ellis LLP ]
- Tarun Warriar, Associate [ Kirkland & Ellis LLP ]

jameshmsprayregen_tarunwarriar

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.

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

“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.

1. The authors would like to express their gratitude to Suharsh Sinha of AZB Partners for his assistance.
2. “Fraudulent preferences” were prohibited under s.328 of the Companies Act 2013. However, the new provisions appear substantially wider in scope.
3. §25(2)(j), IBC and §39(2), Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016.
4. §43(1) and (2), IBC.
5. §43(4)(a) and (b), IBC.
6. §5(24), IBC.
7. §547(b), US Bankruptcy Code.
8. The wide variety of fact patterns in the preference area has resulted in a substantial amount of Judge made law. For example, there are hundreds of US judicial decisions on what payments are considered to be made in the “ordinary course of business” (a defense available to creditors discussed further below). The decisions cited in this article are just a minor sampling from this body of case law.
9. §547(b)(1), US Bankruptcy Code.
10. §548, US Bankruptcy Code.
11. §45(1), IBC.
12. See the broad range of orders the NCLT may make if it determines there has been a preferential transaction under §44, IBC.
13. Gladstone v. Bank of Am. (In re Vassau), 499 B.R.864,872 (Bankr. S.D.Cal.2013).
14. Capmark Fin. Grp. Inc v. Goldman Sachs Credit Partners L.P, 491 B.R.335 (S.D.N.Y.2013).
15. Clear Thinking Grp. LLC v. Brightstar US, Inc (In re KCMVNO) 2010 WL 4064832 at 4-5 (Bankr. D. Del. Oct 15, 2010).
16. §547(e)(2)(A) to (C), US Bankruptcy Code.
17. §547(e)(1), US Bankruptcy Code.
18. §43(3), IBC.
19. The “ordinary course of business” and “security interest in property” for “new value” defenses are in §547(c)(2) and (3) of the US Bankruptcy Code respectively.
20. Burtch v. Detroit Forming Inc (In re. Archway Cookies), 435 B.R.234, 240-245 (Bankr. D. Del. 2010).
21. Union Bank v. Wolas, 502 U.S. 151 (1991).
22. Arrow Elecs, Inc v. Justus (In. Re. Kaypro), 218 F.3d 1070, 1073-76 (9th Cir.2000).
23. United Rentals Inc v. Angell, 592 F.3d 525,531-35(4th Cir.2010).
24. Cadle v. Mangan (In re Flanagan), 503 F.3d 171, 184 (2d Cir, 2007).
25 §547(c)(4), US Bankruptcy Code.

 

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


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