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"Enhancing vigilance in insolvency cases: The imperative for scrutinizing preferential, undervalued, fraudulent & extortionate transactions & empowering stakeholders”
The Insolvency and Bankruptcy Code, 2016 (“IBC or the Code”) was enacted with the primary objective of facilitating a resolution of insolvency for companies. The code aims to provide a well-defined, time-bound, and efficient process for resolving insolvency and bankruptcy of corporates in a transparent and accountable manner. Its overarching goal is to ensure the preservation and maximization of the value of the debtor's assets, while also seeking to balance the interests of all stakeholders, including creditors, debtors, and employees. Additionally, the Code places significant importance on fostering entrepreneurship, taking risks & innovating within the business environment, with the aim of facilitating a resurgence in the event of unsuccessful endeavors.
Moreover, the Code is designed to prevent the premature collapse of viable businesses, thereby protecting the interests of various stakeholders associated with the corporate entity. It is acknowledged that many corporates experience insolvency as a result of fraudulent activities perpetrated by the company's promoters. These activities encompass a range of transactions, such as preferential dealings with parties closely connected to the directors, undervalued transactions with close associates or relatives, fraudulent transactions, and extortionate dealings. These transactions collectively fall under the umbrella of avoidance or preferential transactions, as covered by Sections 43, 45, 50, and 66 of the IBC. This includes Preferential, Undervalued, Fraudulent, and Extortionate (PUFE) transactions, each with specific legal provisions aimed at addressing and rectifying such malpractices within the corporate insolvency framework.
The Code stipulates that all transactions of this kind must be recognized by the Resolution Professional. If the Resolution Professional believes that the Corporate Debtor engaged in avoidance transactions during the relevant period, he/she must request appropriate orders from the adjudicating authority under Section 44 for preferential transactions, Section 48 for undervaluation transactions, Section 51 for extortionate transactions, and Section 67 for fraudulent trading or fraudulent transactions.
It is important to note that only the Resolution Professional is authorized to apply to the Adjudicating Authority for appropriate orders under these sections, if it is believed that these transactions occurred during the relevant time. The law therefore places a significant responsibility on the Resolution Professional to identify and take action on such transactions.
The primary objective of initiating proceedings under PUFE transaction provisions is to reclaim the money or assets owned by the corporate debtor that may have been misappropriated or fraudulently transferred, with the intention of defrauding the creditors or for other fraudulent purposes.
For instance, Section 66 of the IBC Code states as follows:
“If during the corporate insolvency resolution process or a liquidation process, it is found that any business of the corporate debtor has to be carried on with intent to defraud creditors of corporate debtor or any fraudulent purpose, the adjudicating authority may on application of Resolution Professional pass an order that any persons who were knowingly parties who were carrying on business in such manner shall be liable to make contributions to the assets of the corporate debtor as it may deem fit.”
Thus, it becomes the exclusive responsibility of the Resolution Professional to identify any such transactions, assess their value for the purpose of recovery, and submit an application to the Adjudicating Authority for necessary orders.
The capability of every Resolution Professional to effectively identify and assess transactions is a critical consideration. This is due to the fact that an individual can qualify as a Resolution Professional if they are a Chartered Accountant, Company Secretary, Cost Accountant, or an Advocate who has passed the Insolvency Examination and has a minimum of 10 years of experience, and is registered with associations such as Bar Council of India or States or Institute of Chartered Accountants of India. Furthermore, any graduate from a recognized university who has passed the Limited Insolvency Examination and possesses 15 years of management experience is also eligible for enrolment as a Resolution Professional.
Chartered Accountants and, to a lesser extent, Cost Accountants possess comprehensive expertise in accounts, finance, costing, and banking, which enables them to recognize such transactions effectively within a corporate setting. Conversely, Company Secretaries and Advocates have comparatively less exposure to accounts, finance, and banking, with Advocates and graduates lacking in-depth knowledge of important financial and accounting aspects. Additionally, even accounting professionals require at least a limited understanding of forensic accounting to effectively identify, form an opinion, and ascertain PUFE transactions, with or without the assistance of a forensic auditor, and quantify the same.
In a recent case, the total claims accepted by the Resolution Professional of Power Max India Pvt Ltd amounted to INR 48.36 Crores, and the liquidation value of the Corporate Debtor was determined to be INR 4.08 Crores. An application was submitted for the approval of a Resolution Plan with a value of INR 4.01 Crores, resulting in a significant reduction of about 92%. The Resolution Professional engaged a transactional auditor to conduct an audit for two financial years, concluding that no avoidance transactions had occurred, and hence no applications were submitted under PUFE.
The Hon’ble National Company Law Tribunal of Kolkata comprising of Smt. Bidisha Banerjee (J) and Shri. D. Arvind (T), while approving the Resolution Plan that catered to only 8% of the total admitted claims, emphasized the significant responsibility placed on the Resolution Professional by the Insolvency and Bankruptcy Code 2016, regarding avoidance transactions under Sections 43, 45, 50, and 66 during the Corporate Insolvency Resolution Process of the Corporate Debtor. The Tribunal members further noted that the committee of creditors involved in the Corporate Insolvency Resolution Process of the Corporate Debtor lacked the capacity to dedicate full-time attention or form an opinion to identify the avoidance transactions in a corporate debtor.
The Bench further emphasized that the Resolution Professional's failure to form an opinion on avoidance transactions and to file an application before the Adjudicating Authority would result in the inability to retrieve diverted funds for the insolvency resolution of the corporate debtor. They stressed the Resolution Professional's duty to bring to the Committee of Creditors’ attention the whereabouts of the borrowed funds, particularly in cases such as this one, where the haircut is as high as 92%. The bench also noted that the scrutiny for preferential transactions should extend beyond 3 years from the period in which the corporate debtors experienced losses and defaulted on debt payments, in order to effectively identify fraudulent transactions. The bench therefore directed the Resolution Professional to conduct a thorough examination of the Financial Statements, Income Tax Returns, GST Returns, Cash Flows, and Fund Flow Statements and to provide a report with justifications to the Committee of Creditors of the Corporate Debtor, elucidating why an opinion was formed on the absence of preferential or avoidance transactions.
In the context of the overall situation, in instances where the projected value falls below 50% of the accepted claims, it should be obligatory for the insolvency Resolution Professional to engage a forensic auditor and scrutinize Preferential Undervalued Fraudulent or Undervalue Transactions (PUFE) for the purpose of assessment. Essentially, the insolvency Resolution Professional should be vigilant to the possibility of transactions aimed at evading obligations, particularly when the reduction in payout from the plan is greater than 50% of the total recognized claims or the liquidation value. Furthermore, the legislation should be amended to allow any party with a vested interest, such as financial creditors, to submit applications pertaining to PUFE transactions.
Authored by Meghna Arvind, Lawyer & Company Secretary who is currently practicing as an Advocate in Mumbai
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