Insolvency: Are recoveries from avoidance transactions going puff?

Avoidance transactions are of four kinds, forming what we may call the PUFE quartet: for Preferential, Undervalued, Fraudulent and Extortionate. 

A Preferential transaction is one in which one party is favoured over another for payment; an Undervalued one involves the transfer of assets at a reduced value; a Fraudulent transaction is one that amounts to outright deception; and an Extortionate credit transaction implies the payment of exorbitant interest or exercise of other unfair loan terms.

The question is who has the right to pursue PUFE transactions under the IBC: creditors, the resolution professional (RP) of the insolvent corporate, or the winning bidder (i.e. the successful resolution applicant or SRA)? The answer will have a bearing on recoveries. 

The appellate tribunal in 63 Moons Technologies vs. The Administrator of Dewan Housing Finance Corporation Ltd had ruled against the SRA, but an appeal against that judgement is pending in the Supreme Court. 

In Kapil Wadhawan vs. Piramal Capital & Housing Finance, the appellate tribunal allowed the SRA to pursue PUFE transactions only if the resolution plan explicitly permits the same. 

In Tata Steel BSL vs. Venus Recruiters, a division bench of the Delhi high court seems to support the proposition that PUFE-reversal benefits should accrue to creditors if the treatment of such transactions is not part of the resolution plan.

The division bench also stated that the RP can pursue PUFE transactions. However, the tribunal is to determine the method and manner of the RP’s remuneration. This creates a challenge post the completion of a corporate insolvency process. 

The RP may no longer have the authority to act as an insolvency professional or may not be interested in PUFE pursuit. The IBC is silent on appointing new RPs in such a scenario. Moreover, who is to remunerate RPs, given the uncertainty over who the benefits would accrue to?

Also, PUFE transactions need to be litigated before regular recoveries are made. Shell companies created for the purpose may have been liquidated or closed, obfuscating the trail. 

Unravelling such transactions requires investigative asset tracing, which entails costs. Who will fund it? Some litigation financiers, or third parties that offer finance in exchange for a portion of recoveries, might be interested. However, who should enroll litigation financiers for this: creditors or the SRA?

Some creditors believe that PUFE transactions primarily pertain to cases where promoters had issued personal guarantees, and so the amounts would be recovered by them in the personal insolvency proceedings against promoters. 

But then, there are also cases where the composition of a guarantor’s creditors differs from that of the company that undertook avoidance transactions, creating a conflict.

Additionally, recoveries from personal bankruptcy may not materialize where the ultimate beneficiary of PUFE transactions cannot be traced or does not have a direct nexus; this is a near certainty in cases where these transactions were premeditated.

Also, in corporate insolvency, avoidance is done through alienation of corporate assets, whereas in personal bankruptcy, it is through alienation of an individual’s personal assets. 

In the former, one can infer avoidance from account books, but in the latter, asset acquisitions may not be recorded to begin with, obviating the need for their alienation and making it difficult to identify avoidance.

Moreover, the provisions for preferential and undervalued transactions are toothless in personal bankruptcy. Most guarantors of insolvent corporates have themselves been in insolvency for two years, the period prescribed to determine avoidance in personal bankruptcy. 

The probability of a guarantor executing an avoidance transaction whilst in insolvency is low; note that an interim moratorium is in operation during this period.

For creditors hoping for recovery through personal bankruptcy, a recourse path lies in identifying fraudulent transactions (typically involving the concealment of personal assets) by promoters, arising from PUFE transactions indentified during corporate insolvency, where the de facto ultimate beneficiary is the promoter but is prima facie not identifiable as such. 

This may require asset tracing that spans multiple jurisdictions, different corporate structures, trusts, shell companies, etc. In the event that such assets are identified, an ownership challenge and concomitant litigation would probably ensue in different jurisdictions.

Asset tracing and litigation across jurisdictions is expensive. Recoveries would go to creditors in cases of personal bankruptcy, though we lack clarity on beneficiaries in corporate insolvency cases of PUFE transactions. 

This complicates the challenge for litigation financiers who may be interested. They need clarity on whether they are to be given a mandate by creditors of the company, the creditors of individuals involved in personal bankruptcy or the SRA.

It would be a pity if this uncertainty persists, as it could lead to recoverable PUFE transactions turning into a puff of smoke. Let’s hope the IBC sorts all this out.