Fraud and its derivatives (quasi-fraud) are common in the corporate world. The evolution of corporate laws have been shaped by fraud in order to protect against it. The Insolvency and Bankruptcy Code also addresses potential frauds and how they may arise in the insolvency process.
To understand fraud and quasi-fraud vis a vis IBC, it is first necessary to understand the basic objective of the Code. The basic objective of the Code is to ensure that the sick company i.e. unable to repay its debt is resolved or revived in a manner that addresses interests of all related stakeholders and is time-bound. Thus, any transaction, act or dealing that is contrary to the basic objective of the Code can be understood either as fraudulent or vulnerable.
Difference Between Fraudulent And Vulnerable Transactions
There are several famous legal maxims that effectively explain fraud being “once a fraud always a fraud” and “fraud vitiates every transaction into which it enters.” Fraud is simply the wrongful doing of anything by a person that results in his unlawful gain. Fraud implies that there is an active intention and deliberate action taken in furtherance of that intention in order to achieve that unlawful gain. Thus such transactions would be deemed fraudulent.
On the other hand, vulnerable transactions are those that are done without any intention to do any wrongdoing but are still vulnerable to legal action because of non-compliance of existing statutes. One may not have intended to transact in a manner to make wrongful gains but that transaction would still be illegal as per law. Thus, in IBC, fraudulent and vulnerable transactions are enshrined in the provisions of Sections 43-51 and 66 & 67.
Vulnerable or avoidable transactions are classified into three categories:
i. Preferential Transactions
ii. Undervalued Transactions
iii. Extortionate Credit Transactions (not talked about)
Preferential transactions as the name suggests is a transaction that is ‘preferential’ in nature between the corporate debtor and creditor. The Corporate Debtor through the impugned transaction puts the creditor in a ‘beneficial position’ which he would have otherwise not been in. The implication of putting one creditor in a beneficial position over the other is that other creditors are unfairly discriminated against during liquidation. Thus a preferential transaction can be said to be any such transaction which has “an adverse bearing on the financial health of the distressed corporate person or turns the scales in favour of one or a few of its creditors or third parties, at the cost of the other stakeholders.” The essentials of a preferential transaction can be summarized as follows:
Transfer of Property or Interest- the CD transfers either some property or interest to the creditor.
Transfer is for clearing existing Financial or Operational Debt- the transfer is made as against the debt owed by the CD to the creditor
Transfer is made to related or other party in relevant time- the transfer is made to a related party during 2 years preceding the insolvency commencement date or 1 year in the case of other persons.
Transfer puts party in ‘Beneficial Position’- the transfer puts the creditor or whoever the case may be in a better position than he would have been in otherwise had liquidation been conducted duly as per Section 53.
For example, A is an unsecured creditor of B. A has given a loan without obtaining any security against it. B defaults on the loan and goes into liquidation. Since A is an unsecured creditor, his claims are not at the top in terms of priority of realization. Therefore, B now creates an interest in favor of A on one of his properties. This has now resulted in A’s position going from unsecured to secured creditor. This has resulted in benefit to the position of A. Hence such a transaction is preferential.
The exceptions to preferential transactions are those transactions conducted in the ordinary course of business or those that create a security interest securing a new value. The practical hurdles that arise now are in distinguishing what amounts to ordinary business and what does not? How is one to keep a check against the CD doing such an act? The IBC mandates the RP or Liquidator to apply for restraining orders in case of preferential transactions. But what if the RP or Liquidator himself is involved in such a transaction? Who can file for a remedy then? Thus, these are the challenges that arise with respect to preferential transactions.
Undervalued, as the name suggests, are those transactions that are not made for their fair value. For the purposes of the Code these transactions are when the CD either makes a gift to a person or transfers an asset for a consideration significantly lesser than what the CD had paid for it. A further caveat imposed is that such transaction must have not taken place in the ordinary course of business. The questions that arise with respect to determining and protecting against undervalued transactions are as follows:
1. What is ordinary course of business?
Section 45 implies that if a gift or undervalued transfer (impugned transaction) has taken place in the ‘ordinary course of business’ then it is acceptable. But what is the criteria in establishing ordinary course of business? When is the conduct not ordinary? Section 46 provides some answer to this question by defining a time period for such a transaction. It outlines that any such impugned transaction if falling within 2 years prior (in the case of related party) or 1 year prior (in the case of any other person) shall be undervalued. Thus practically speaking, the information memorandum and asset memorandum revealing transactions of such nature through the balance sheet of the company would come under scrutiny. But yet again, proving whether it was made in the ordinary or otherwise course of business would be critical in determining if such a transaction is undervalued or not.
2. What is ‘significantly less’?
Those transactions where the asset of the CD is transferred for a value ‘significantly less’ than that which the CD bought it for would be deemed to be undervalued. The problems that arise with this is in determining what is significantly less. That is a very subjective question as it depends on the asset itself. There is no definition of asset provided under the Code and hence an asset could also be in the nature of a receivable loan in the company’s books. Would transfer of interest in that loan amount to transfer of the asset? Is that within the ordinary course of business? What effect does depreciation of the asset have on determining if the value is significantly less or not? Such questions elucidate the practical hurdles faced by undervalued transactions.
Fraudulent Or Wrongful Trading
Section 66 of the Code deals with the overarching concepts of Fraudulent or Wrongful Trading. 66 (1) talks about fraudulent trading whereas 66 (2) talks about wrongful trading either during the CIRP or Liquidation process.
Section 66 (1)- imposes liability on those persons that were party to carrying on of business with dishonest intention of defrauding creditors. Such persons have to personally contribute to the assets of the corporate debtor. Only the RP as per the section can file an application for alleging such fraudulent or wrongful trading.
There is a huge defect in this provision which has not been addressed anywhere in the Code.
Section 25 (1) states that it shall be the duty of the RP to preserve and protect the assets of the corporate debtor including the continued business operations of the corporate.
Section 66 (1) states that if during the CIRP or liquidation process the business of the CD has been conducted with an intent to defraud the creditors or for any other fraudulent purpose then the RP himself must apply to the NCLT for rectification under this section. The contradiction that arises is that if the RP/Liquidator himself is in charge of conducting the business of the CD during CIRP or liquidation then how can any other person but the RP himself be responsible for fraud? If the responsibility to handle the operations and conduct of the CD during the CIRP or liquidation is with the RP then how can fraud arise if not for either negligence or involvement of the RP in the fraud? What situations are there that can lead to fraud in the business of the CD during the CIRP or liquidation otherwise?
Furthermore, how can only the RP bring such application? Assuming the RP is responsible or contributing to the fraud, should the creditors not be allowed to voice their concerns through channels other than the RP himself? Such questions are to be deeply considered in the author’s opinion.
Moving on beyond the above mentioned point, 66 (1) implies that persons entering into transaction should have had knowledge that there is no reasonable prospect of repayment of debt. Thus, the features of fraudulent trading can be summarized as follows:
- Dishonest Intention- proving this is very subjective to the facts and circumstances of the case.
- Any persons- any persons includes not only insiders such as employees, directors, partners but extends to include fraud on behalf on any 3rd party e.g. creditors, corporate persons etc.
- Liability to personally contribute by such persons- to the extent ‘deemed fit’ by the NCLT. This also can raise questions as to how is the Tribunal supposed to determine what level of personal contribution is fit or not?
- No defined look-back period- this allows involved parties to be held liable for acts committed even prior to liquidation that are within ‘look-back’ period. Look back period is provided for undervalued transactions but is not specified here so as to ensure a strict standard of liability for the fraudsters.
Wrongful trading is different than fraud in that it restricts the imposition of liability only on the director or partner of the CD. The liability accrues on the director or partner when:
a. The director or partner knew or ought to have known that insolvency proceedings were impending AND
b. Did not take reasonable steps to mitigate the loss to the creditors of the CD in light of having or having to have known such fact.
Basically, the director or partner had to exercise due diligence in minimizing the potential loss to creditors of the CD. Thus, unlike fraud, the presence of dishonest intention is not material as even negligence on part of the directors or partners suffices to attract liability.
Under this section, directors have to ensure no further debts are incurred by the company in twilight period and also ensure that subsequent revival and rehabilitation measures are promptly taken. The twilight period is the period between when directors know or ought to have known that insolvency is forthcoming and when the process is actually initiated. Directors are expected to take positive action to mitigate creditor losses in this time and their actions being determined wrongful under 66 (2) depend solely on the actions taken during this period.
The practical difficulties that arise in this section are in determining what amounts to a director knowing? When does the twilight period begin? What amounts to exercise of due diligence? How can one ascertain if the loss has been mitigated or not?
In conclusion, fraudulent and quasi-fraudulent transactions are broad in nature and can encompass various elements within them. It is possible for a transaction to be in the nature of a preferential, undervalued and fraudulent transaction as well. Such considerations were brought about in the famous case of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited. Thus, there are several practical hurdles, aspects and considerations that are involved in transactions of a fraudulent nature.
 Anuj Jain v. Axis Bank, 2019 SCC Online SC 1775