Supreme Court Clarifies Key Differences Under IBC: Avoidance Transactions vs. Fraudulent Trading

In a landmark judgment in Piramal Capital and Housing Finance Ltd. v. 63 Moons Technologies Ltd., the Supreme Court of India clarified the crucial distinctions under the Insolvency and Bankruptcy Code, 2016 (IBC). This judgment has far-reaching implications for insolvency proceedings as it distinguishes between "avoidance transactions" and "fraudulent or wrongful trading" for the purposes of asset recovery and director accountability.

Understanding Avoidance Transactions

Avoidance transactions are specific pre-insolvency deals that harm creditor interests. They fall under Chapter III of the IBC and are primarily addressed through:

• Preferential Transactions (Section 43):
  • Occur when the corporate debtor provides undue advantage to a creditor or guarantor prior to insolvency.
  • Such transactions can be reversed to ensure fair treatment among all creditors.
• Undervalued Transactions (Section 45):
  • These involve transferring assets at substantially lower values than their true market worth.
  • The law mandates reversing such deals to prevent one creditor from gaining an unfair advantage.
• Extortionate Credit Transactions (Section 50):
  • Dealings where a company borrows on terms that are excessively harsh shortly before the onset of insolvency.
  • The resolution professional (RP) is empowered to challenge such transactions.

In practice, the RP is required to file avoidance applications - without affecting the overall Corporate Insolvency Resolution Process (CIRP) - to safeguard the debtor’s assets for equitable distribution among creditors.

Distinguishing Fraudulent or Wrongful Trading

In contrast fraudulent or wrongful trading, which falls under Section 66 of Chapter VI of the IBC, deals with the overall conduct of the company during insolvency:

• Fraudulent Business Conduct:
  • This involves deliberate mismanagement or fraudulent activities aimed at defrauding creditors.
  • The focus here is not on a single transaction but on the management’s overall intention.
• Personal Liability and Broader Inquiry:
  • Under Section 66(1), if directors or partners continue business operations knowing that insolvency is inevitable, they may be held personally liable.
  • Here, the adjudicating authority examines the intent behind decisions rather than reversing a specific deal.

Unlike avoidance applications, which can be easily identified and undone, establishing fraudulent or wrongful trading requires a deeper investigation into whether the management acted with an intent to cheat creditors.

Judgment Highlights and Legal Implications

The Supreme Court's judgment emphasized several key points:

• Separate Judicial Mechanisms:
  The powers available under Sections 25 and 66 operate in distinctly different judicial contexts. Avoidance applications (Sections 43, 45, and 50) are remedial measures meant to reclaim assets, while fraudulent trading provisions require a broader inquiry into managerial misconduct.
• Role of Resolution Professionals:
  Resolution professionals must accurately file avoidance applications based on specific, clearly identifiable transactions without interfering with the broader insolvency process.
• Limited Scope for Adjudicating Authority:
  The court reiterated that the adjudicating authority's review is confined to verifying compliance with statutory requirements, not re-assessing the commercial wisdom of the Committee of Creditors (CoC).
• Practical Impact on Recovery:
  In the DHFL case, for instance, the treatment of recoveries from avoidance transactions was a significant issue. The Court directed that funds recovered from these transactions must benefit all creditors rather than being appropriated solely by the successful resolution applicant.

Key Takeaways for Stakeholders

• For Resolution Professionals:
  Clearly distinguish between filing for avoidance transactions and addressing fraudulent trading. Ensure each application is grounded in the proper statutory provision.
• For Creditors:
  Understand that recoveries from avoidance transactions are designed to benefit all creditors, while fraudulent trading measures target the wrongful actions of management.
• For Directors and Management:
  Exercise due diligence and maintain transparency in business operations. Misconduct that leads to fraudulent trading may result in personal liability under Section 66.

Conclusion

The Supreme Court's judgment provides much-needed clarity on the distinct legal treatments of avoidance transactions versus fraudulent or wrongful trading under the IBC. By demarcating these areas clearly, the ruling reinforces the integrity of the insolvency resolution framework, ensuring that asset recoveries are conducted fairly and that wrongful business conduct does not go unchecked. This decision stands as an important milestone in promoting transparency and accountability in corporate insolvency proceedings.