Avoiding preferential transfers by debtors

By Charanya Lakshmikumaran and Gopal Machiraju, Lakshmikumaran & Sridharan
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Creditors are often faced with circumstances in which debtors have transferred their assets, thus reducing the assets available for distribution in cases of insolvency or liquidation. Section 53 of the Transfer of Property Act, 1882 (TPA), provides the first set of solutions for such creditors. It provides that a transfer of immovable property made with intent to defeat or delay the rights of the creditors of the transferor shall be voidable at the option of any creditor so affected. The rights of a transferee in good faith and for, consideration are, however, protected. An action for setting aside such a transfer can be instituted on behalf of, and for the benefit of all creditors. The provision, known shortly as fraudulent transfer, requires that it be demonstrated that the intention of the debtor was to defeat or delay the claims of the creditor.

Arbitration
Charanya Lakshmikumaran
Partner
Lakshmikumaran & Sridharan

An action under section 53 of TPA is not maintainable against the debtor in circumstances where the moratorium mechanism of the Insolvency and Bankruptcy Code, 2016 (IBC), has come into operation. However, this does not leave creditors without a remedy as a transfer that cannot be avoided under section 53 may be avoided under section 43 of the IBC. Section 43 of the IBC allows preferential transfers to be avoided. A preference is deemed to arise when the transfer is for the benefit of any existing creditor or a surety in respect of an existing debt. This transfer should further, and usually will be shown to, have the effect of putting such creditor or surety in a better position than it would otherwise have been in the event of the insolvency of the debtor. Such a transfer may be avoided by the resolution professional or the liquidator by making an application to the adjudication authority (AA). Under section 43, the debtor’s intention to create a preference is irrelevant, unlike the situation under section 53 of the TPA.

transfers
Gopal Machiraju
Senior associate
Lakshmikumaran & Sridharan

While section 53 of the TPA and section 43 of the IBC operate in different spheres, there are instances where proceedings under the IBC are brought solely to avoid such transfers. In such cases, it may first be prudent to examine which of section 53 or section 43 offers the more appropriate relief. While several factors, including the nature of the interest in the property transferred, the security interest over the property and the value of the property, are relevant, two factors are of particular practical importance.

First, an action under section 43 of the IBC is only available in respect of transfers made within one year preceding the insolvency commencement date (ICD) and two years in the case of a transfer to a related party of the debtor. Section 43 is anomalous in that the above period is to be reckoned with reference to the ICD, as opposed to the date of initiation of the proceedings. Debtors often take advantage of this provision by prolonging proceedings long enough to put a transaction outside the reference period. This is particularly so when the debt is operational debt. On the other hand, an action under section 53 is subject to the ordinary rules of limitation, and is a single tier proceeding, that is it does not require the adjudication of a prior proceeding.

The second factor is third-party interests in the assets and the applicability of the rule of lis pendens (that is, a pending legal action). An action under section 53 of the TPA seeks reversion of the transferred property to the estate of the debtor and the rights to such property are therefore directly and specifically in question. Thus the doctrine of lis pendens must apply and any third-party rights created while the proceedings are pending are subject to the outcome of the suit.

A suit may thus allow the property to be ring fenced and protected from the creation of third-party interests. The question as to what happens to third-party rights when transfers are avoided under the IBC is as yet uncertain and will have to be resolved by litigation. The intention of the legislature appears to be to save third-party rights, as section 43 can only make the first transfer voidable, as opposed to section 45 (which deals with undervalued transactions), which can declare the first transfer to be void and may affect subsequent transferees.

Since the ability to avoid fraudulent transfers and preferences is fundamental to insolvency, creditors should weigh their options under the IBC as well as other provisions, such as those in the TPA, in determining their recovery strategies.

Charanya Lakshmikumaran is a partner and Gopal Machiraju is a senior associate at Lakshmikumaran & Sridharan.

Lakshmikumaran & Sridharan
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India
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