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Avoidance of Land Contracts Under Insolvency and Bankruptcy Laws

Introduction

A company is an artificial person that exists to serve a purpose, but some circumstances could cause it to fail. When a company fails, it could potentially eliminate jobs for everyone connected to it and have a detrimental effect on the nation’s economy.

Every effort is made to prevent this from happening, but when it couldn’t be helped and an organization is about to enter into insolvency proceedings, the transactions and agreements made by the organization prior to the start of those proceedings are assessed, and those that are found to be detrimental to the organization and those connected to it or that violate the interests of the debtor or the creditor are deemed null and void. Avoidance of pre-bankruptcy procedures is the name of the process.

The laws governing insolvency and bankruptcy have figured out how to strike a balance between the rights of the debtor and the creditor. The debtor cannot be forced to sell off assets like shares of stock, real estate, or other assets, or to sign a contract that goes against his rights or interests in any way by creditors of the entity with the authority to collect debts from the debtor’s estate. The activities taken and agreements made in this regard are avoidable and preventable in order to safeguard the interests of the debtors, and as a result, are referred to as avoidable transactions.

The protection of debtors’ assets, their maximization as a value, and the availability of credit in place of those assets continue to be the goals of avoidable transactions. Ultimately, improving the company’s financial situation and streamlining the resolution procedure will result in a fair allocation of the assets.

Prior to the start of the insolvency proceedings, the two parties may enter into contracts involving simple assets like shares, buildings, or land or more complex agreements like those involving a franchise, taking over construction projects, etc. Given its prominence and value as one of a company’s most precious assets, the land would be a target for any creditor who set out to pay off their debts to the debtor while ignoring other creditors. Land contracts between a creditor and a debtor should be avoided in addition to all other contracts.

The UNCITRAL model, in accordance with part 2 of its legislative guide, calls for the avoidance of specific transactions on the part of the debtor in order to guarantee the treatment of all creditors equally and protect the rights of the debtors and prevent them from being coerced by creditors into entering into a contract for the transfer of any asset at a value that is less than its true value.

Avoiding favoritism on the part of the debtor is another way to look at the situation. The debtor can prefer one creditor over another and get into an agreement with him on the transfer of an asset as soon as they learn that bankruptcy procedures will soon begin.

To ensure the preservation of the rights of all parties involved, these transactions that were made before the start of the insolvency procedures are canceled or declared to be ineffective. There are differences between the rules of different countries, even though different jurisdictions have based their insolvency laws on the UNCITRAL model.

Under sections 43 to 51 of the 2016 Insolvency and Bankruptcy Code, transactions that can be avoided, commonly known as vulnerable transactions, are addressed.

Under the IBC, the following transactions can be avoided:

  1. Preferential Transaction
  2. Undervalued Transaction
  3. Extortionate Credit Transaction

According to section 46 of the 2016 IBC, the debtor must avoid the aforementioned transactions throughout the relevant period, which is two years in the case of a related party and one year in all other cases before the insolvency beginning date.

Model and Avoidance Procedures for UNCITRAL

The UNCITRAL Model Law is intended to help States give their insolvency laws a contemporary legal foundation so that they can deal with cross-border insolvency processes involving debtors who are in serious financial difficulty or insolvency more efficiently1. The legislative guide is composed of four parts on insolvency legislation, covering the objectives, structural issues, mechanisms for resolving the debtor’s financial difficulties, the start, termination, and avoidance of proceedings, as well as other similar provisions that call for detailed consideration.

In the legislative guide’s part 2 on debtor rights, it is stated that it is preferable for the right to keep those excluded assets to be made clear in the insolvency law when a debtor is a natural person and that certain assets are typically excluded from the insolvency estate to allow the debtor to preserve its rights and those of its family2.

Avoidance proceedings are likewise covered by recommendations 87 to 99 in the same section of the legislative handbook. The avoidance proceedings are based on a general principle of insolvency law that gives priority to the collective goal and overall maximization of the value of the assets and credit availability to facilitate equal treatment for all the creditors and the debtor’s rights rather than providing individual remedies to the creditors who could claim the assets by entering into a contract with the debtor before the commencement of the insolvency proceedings.

“Provisions dealing with avoidance powers are designed to support these collective goals, ensuring that creditors receive a fair allocation of an insolvent debtor’s assets consistent with established priorities and preserving the integrity of the insolvency estate,” reads a statement about this in the guide.

The UNCITRAL model also stipulates a few avoidance criteria. There are several factors, including the normal course of business, defenses, and both subjective and objective criteria. The state may choose any of the criteria as long as the overall goal—to strike a balance between the interests of the individual and the estate—remains the same.

Criteria

  1. Objective Criteria: The focus is on measurable issues, such as whether the transaction occurred during the questionable time frame and whether it demonstrated any of the several broad legal requirements.
  2. Subjective Criteria: The subjective approach is more case-specific, and the issues that might come up include whether there was a desire to conceal assets from creditors and when the debtor became insolvent—whether that occurred during or after the transaction.
  3. Combination of the two: The majority of states’ insolvency laws are more subjective in nature, but they also provide a deadline by which the transaction must have been completed. For instance, in India, the applicable period is two years for a related party and one year for any other creditor.
  4. Ordinary Course of Business: There is a distinction made between what might be seen as a routine or ordinary business transaction and what is extraordinary and ought to be avoided as part of an avoidable transaction. Along with conventions and standard business practices, the debtor’s prior actions may have an impact here.

The states are allowed to use either of the criteria as a starting point when deciding how to handle the aforementioned unnecessary transactions.

Avoidance tactics used worldwide

Different jurisdictions follow different sets of avoiding powers; by classifying them broadly, we can conclude that there are single sets and double sets of avoiding powers. Civil law countries like France and Spain are followers of a single set of avoiding powers, whereas common law countries follow a double set of avoiding powers. As previously stated, the UNCITRAL model is merely providing a guide to the states to formulate proper avoidance actions.

  • American Viewpoint: A technique to invalidate perfectly legal transactions because they were made before the start of insolvency proceedings is the use of clawback actions or avoidance powers. The usual justification for invalidating such a deal is that the creditors who would be getting the firm’s assets but losing all control over them once the formal processes started would try to seize control of them beforehand by manipulation or other unethical ways. The transactions made before the bankruptcy proceedings, as was already indicated, are detrimental to the firm’s assets worthwhile also violating the rights of the debtor and other creditors. The goal of American bankruptcy law is to give creditors the most advantage possible.
  • Automatic Stay: A fundamental tenet of the American insolvency regime is the automatic stay. When insolvency procedures begin, the rules of the automatic stay described in Section 362 of the bankruptcy code take effect. Any creditor would not be able to seize any assets or property from the debtor as a result of the stay. By allowing the creditors to pursue their recovery options, this approach benefits them. However, there are some exceptions to the automatic stay, and the court can change it if there is a good basis to do so. Creditors are protected by the automatic stay because it prevents the value of the debtor’s property from declining and guarantees that it is distributed fairly.
  • Absolute Priority Rule: Another important tenet of the US insolvency process is the Absolute Priority Rule. This rule is based on fairness and equity because it requires that creditors who have investments be paid in priority to other creditors who have smaller investments. Because equity holders have the lowest priority, they will be paid last and secured creditors will be paid first. However, this rule can be circumvented by voting of senior members; if votes of senior members are obtained, payment of junior class or unsecured creditors can be possible.
  • Avoidance action: The bankruptcy law in the US outlines several techniques that let debtors avoid the pre-bankruptcy transfer of assets. Due to the possibility of bias on the part of creditors, this affords debtors the right to raise the worth of their bankruptcy estate and prevent its decline before filing for bankruptcy.
  • Australian Viewpoint: The clauses specified in the Bankruptcy Act, 1924-1946 deal with the transfer of property under Australian law at the time of bankruptcy. It is addressed in Section 95 of the Act, which states that if the debtor declares bankruptcy on a bankruptcy petition filed within six months, any transfer of property, payment, or obligation made in favor of any creditor or person acting in the creditor’s behalf and a creditor a preference, precedence, or other benefits over other creditors, shall be null and void. The Downs Distributing Co. Pty. Ltd. V. Associated Blue Star Stores Pty. Ltd. In the end, the court’s conclusion was influenced by the bankruptcy act’s Ltd provision.
  • Indian Viewpoint: The common law nations influence the avoidance powers of the insolvency and bankruptcy code, which is a relatively young piece of legislation. Contracts for the transfer of assets or property may be the subject of avoidance procedures, which are covered under Sections 43 to 51.

Any contract involving the transfer of any asset or property may be avoided, and the parties may declare any contracts they have entered into to be null and void. Land contracts are no exception; the Jaypee Infratech Limited v. Axis Bank Limited case is the ideal illustration of how to prevent a transaction based on the transfer of real property.

In this instance, the holding company of Jaypee Infratech Limited, Jaiprakash Associates Limited (JIL), established the aforementioned subsidiary as a special purpose vehicle for the construction of an expressway and entered into a contract with the Yamuna Expressway Industrial Development Authority. Loans were obtained for this purpose from several banks jointly, and the land and 51 percent of JIL’s stock were mortgaged.

Later, when an IDBI bank petition was filed about it, some of JIL’s lenders declared it to be a non-performing asset, and the NCLT issued an order under section 7 of the IBC, 2016 to start the insolvency procedures. The corporate debtor engaged in transactions that resulted in an obligation on its immovable property, and those transactions were alleged to have been preferential, undervalued, and fraudulent in the application submitted by the designated IRP.

The request was reviewed and approved. The creditors filed an appeal to invalidate the NCLT orders.

The issues, therefore, faced by the supreme court were as follows:

1. Whether the transactions entered into by the debtor undervalued, preferential and fraudulent?

2. Whether the respondents were financial creditors given the fact that the property was mortgaged to them?

The land was mortgaged, according to the NCLT, to mislead the lenders. The debtor was already in financial trouble at the time the transactions were made, and the creditors were aware of the debtor’s predicament at the time the mortgage contract was signed. Because the debtor’s only goal was to make money, the adjudicating authority believed that the debtor was attempting to conduct a fraudulent transaction during the twilight period and did not meet the definition of an ordinary course of business.

The appellate authority, on the other hand, determined that the mortgage was made in the normal course of business and therefore section 43(2) was not invoked. Additionally, the transactions were not preferential nor undervalued, and the adjudicating authority cannot issue any directives in this regard.

The apex court determined that the debtors had engaged in a preferential transaction in terms of preference. The supreme court upheld NCLT’s ruling and declared that section 433 applied to the current situation. A translation must pass the three-fold criteria to qualify as a preferential transaction under this clause, i.e. observing Sections 43(4) and 43(2) criteria, and not violating any of the Section 43 exceptions (3).

The transactions in which the corporate debtor shall be judged to have been granted a preference are discussed in subsection 2 section 43. The clause expressly mentions a corporate debtor transferring property or an interest in that property to a creditor in exchange for payment of financial or operational debt. The clause intends to invalidate any transactions involving the transfer of property in which a corporate debtor granted precedence. hence include transactions relating to land within its purview.

The Goodwill Theaters v. Sunteck Realty, in which it was questioned whether the developer who had been granted development rights by the landowner should be classified as an operational creditor, adopted a different strategy and determined that because the transfer of development rights did not amount to the supply of goods or services, the developer would not be classified as an operational creditor.

The aforementioned transactions specified in subsection 3 will not be regarded as preferential transactions if the transfer is carried out in the ordinary course of business and is establishing a security interest in the property.

Undervalued transactions are another sort of transaction that can be prevented thanks to section 45 of the code. The IRP believed that the transactions in the aforementioned matter of Jaypee Infratech were not only preferential but also undervalued; nonetheless, it was finally decided that the transaction was undervalued. A deal is considered undervalued if the corporate debtor pays less than the asset’s true value.

The aforementioned situation is another illustration of a transaction that may be avoided because it is cheating the creditors. The IBC’s Section 49 addresses the prohibition against deceiving the creditor. This clause would apply if the corporate debtor had purposefully entered into a transaction at a discount.

Last but not least, the IBC allows for exorbitant credit transactions, another category of unnecessary transactions. In Section 50, extortionate transactions are discussed. A transaction is deemed exorbitant if it is unfavorable to the corporate debtor and is made at a time when the debtor is at its most vulnerable. It’s possible that the contract was either blindly signed by the debtor without reading it or that it was purposefully drafted in the creditor’s favor so that the debtor would sign it while at a vulnerable moment.

Conclusion

We have determined that some transactions are avoidable and, as a result, ruled void if there is a conflict between the interests of the debtor and any other creditors, including the firm. Regarding the laws governing such proceedings, diverse perspectives have been adopted by jurisdictions around the world. However, it is important to make very thorough judgments about the deals and agreements made.

They might be produced as part of routine company operations. Land contracts, in particular, the land being one of the most important assets of any business could become an easy target by the creditors who desire to injure the debtor by taking it away at a reduced price, at the same time the debtor could also engage in a land transaction with ill will. To protect the interests of all parties involved, the avoidance procedures must therefore be thoroughly assessed and finally dismissed.


References

  1. UNCITRAL Model on Cross-Border Insolvency (1997) available at https://uncitral.un.org/en/texts/insolvency/modellaw/cross-border_insolvency
  2. UNCITRAL Legislative Guide on Insolvency Law Part 2 https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf Page 167 Point 20.
  3. (1) Where the liquidator or the resolution professional, as the case may be, is of the opinion that the corporate debtor has at a relevant time given a preference in such transactions and in such manner as laid down in sub-section (2) to any persons as referred to in sub-section (4), he shall apply to the Adjudicating Authority for avoidance of preferential transactions and for, one or more of the orders referred to in section 44.

This article is written by Bhagyashri Neware, LLM student from Maharashtra National Law University, Aurangabad.

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