Fraudulent Transactions in IBC - A case study.

Fraudulent Transactions in IBC - A case study. 2020-09-04

Section 49 of the IBC deals with "transactions defrauding creditors". Such transactions are undervalued transactions which are "deliberately" entered into by the corporate debtor either (a) for keeping assets of the corporate debtor beyond the reach of any person who is entitled to make a claim against the corporate debtor; or (b) in order to adversely affect the interests of such a person in relation to the claim.

The key distinction between undervalued transactions and transactions defrauding creditors is the element of intent. While such intent to deprive or adversely affect the right of persons in respect of their claim is irrelevant in the case of undervalued transaction, it must be proven to the satisfaction of the NCLT for a transaction to be considered fraudulent.

Another crucial distinction between such transactions is that there is no "look-back" period for fraudulent transactions. This is in line with the general principle that fraud vitiates everything.

A significant implication of a transaction being found to be fraudulent is the penalty that may be attracted in each case. Under Section 69 of the IBC, officers of a company which has undertaken such fraudulent transactions may be punishable with imprisonment for a term of up to five years and a fine extending up to rupees one crore. No such penalty is prescribed for undervalued transactions.

The provisions relating to preferential transactions and fraudulent transactions protect persons who entered into such transactions in good faith and for value (with the additional requirement of lack of notice of the relevant circumstances in the case of fraudulent transactions).

Following are the excerpts from the orders of the Disciplinary Committee constituted by the Board (IBBI order no. IBBI/DC/15/2019-20 dated 14th November, 2019), detailing one such transaction facilitated by RP, under pressure of CoC. (Names omitted for obvious reasons)

“3.3 Contravention: Section 5(13) of the Code read with Regulation 31 of the IBBI (Insolvency Resolution for Corporate Persons) Regulations, 2016 defines ‘Insolvency Resolution Process Cost (IRPC)’ which does not include fee paid to lender’s legal counsel since they are incurred directly by members of CoC. However, RP included the fee payable to the lender's legal counsel (xxxxx) while calculating IRPC.

Submission by RP: It is submitted that CoC, in its 3rd meeting on 31st October 2017, discussed the fees of xxxxx (lender’s legal counsel), it was clarified by representative of xxxxx (lender’s legal counsel) that the fee of legal counsel of CoC can be charged to CD as a general practice. At that time, there was no specific provision on this point neither any clarity.
(Author’s comments; Lender’s legal counsel tendered biased opinion to CoC, may be due to conflict of interests)
Subsequently, when the Board issued Circular on ‘Fee and other Expenses incurred for CIRP’ on 12th June 2018, RP cited his reservation on the aspect of fees of lender’s legal counsel in 18th CoC meeting forming part of IRPC, but CoC decided to route appointment of and payment to xxxxx (lender's legal counsel) through RP and on receipt of resolution plan, fees payable to lender’s legal counsel may be negotiated with resolution applicant.

It was further decided that if the Board does not allow this arrangement, then the fee amount will be recovered on pro-rata basis from upfront cash recovery amount to be paid to lenders and CoC may negotiate with resolution applicant to pay the fee amount out of their cash flows.

Further, in the 19th CoC meeting held on 10th October 2018, the members passed a resolution to that effect.
(Author’s comments; Do Code & Regulations provide for the approval of IRPC from the Board ? CoC tried to take benefit of the situation that only 15 to 20% of CIRP are being inspected by the Board)

During the personal hearing, it was submitted that Regulation 31(e) of the IBBI (Insolvency Resolution Process for Corporate Persons) Regulations 2016 provides that ‘other costs directly relating to the corporate insolvency resolution process and approved by the committee’ shall be included in IRPC. It was believed that as long as the cost is incurred for maximisation of the value of assets, the cost can be included in IRPC costs. The fee paid to lender’s legal counsel was incurred for rendering advise on CIRP and thus, the same was included as a part of IRPC costs with an undertaking from the members of CoC that if the same is not approved by the Board, the members shall reimburse the same.

Analysis by DC:
It is trite to mention that the IRPC is an added financial stress on a CD. Therefore, it becomes crucial to monitor the expenses incurred by the RP to ensure that a CD, who is already entangled in a web of unsustainable liabilities is not further over-burdened with exorbitantly high IRPC.

An IP is obliged under section 208(2)(a) of the Code to take reasonable care and diligence while performing his duties, including incurring expenses. He must, therefore, ensure that not only fee payable to him is reasonable, but also other expenses incurred by him are reasonable.

Clause 3 of the Code of Conduct as given in the First Schedule of the Insolvency and Bankruptcy Board of India (Insolvency Professional) Regulations, 2016 provides that an insolvency professional must act with objectivity in his professional dealings by ensuring that his decisions are made without the presence of any bias, conflict of interest, coercion, or undue influence of any party, whether directly connected to the insolvency proceedings or not.

Clause 5 provides that an insolvency professional must maintain complete independence in his professional relationships and should conduct the insolvency resolution, liquidation or bankruptcy process, as the case may be, independent of external influences.

Section 5 (13) of the Code defines the term ‘Insolvency Resolution Process Costs’ (IRPC) in the following words -
"insolvency resolution process costs" means—
(a) the amount of any interim finance and the costs incurred in raising such finance;
(b) the fees payable to any person acting as a resolution professional;
(c) any costs incurred by the resolution professional in running the business of the corporate debtor as a going concern;
(d) any costs incurred at the expense of the Government to facilitate the insolvency resolution process; and
(e) any other costs as may be specified by the Board.

As per Regulation 31 of IBBI (Insolvency Resolution Process for Corporate Persons) Regulations 2016:
“Insolvency Resolution Process Costs” under Section 5(13)(e) shall mean –
(e) other costs directly relating to the corporate insolvency resolution process and approved by the committee.

The responsibilities of CoC and IP are clearly demarcated by the Code. The CoC must not encroach upon the role of IP and must not allow the IP to encroach upon its role. Similarly, the IP must not compromise his independence in favour of the CoC.

It is important to note that the CoC or its members do not own the assets of the company rather they hold the assets as trustees for the benefit of all stakeholders. The gain or pain emanating from the resolution, therefore, need to be shared by the stakeholders within a framework of fairness and equity. Further, the CoC has a statutory role. It discharges a public function. It must, therefore, apply the highest standards of duty of care. It must not only follow the due process, but also be fair towards all stakeholders and transparent in discharge of its responsibilities for maximising the value of the assets of the company.

The provisions of the Code as well as IBBI (Insolvency Resolution Process for Corporate Persons) Regulations 2016 does not provide for inclusion of fee paid to the lender’s legal counsel in the IRPC. The RP, during the personal hearing, admitted of having charged the fee of lender’s legal counsel to CD and also, in Addendum dated 30th October, 2019 provided details of the fees paid to lender’s legal counsel in relation to the services rendered by them prior to the issuance of Circular on ‘Fee and other Expenses incurred for CIRP’ dated 12th June 2018.

According to the IRPC details furnished by RP vide e-mail dated 11th November 2019, a sum of Rs. 12,09,90,185/- paid to legal counsel of CoC forms part of IRPC. Further, out of above, an amount of Rs. 1,47,89,315/- has been paid to the lender's legal counsel for bills raised on 06.10.2017, 09.01.2018 and 07.03.2018 during CIRP but prior to the issue of the Circular. As per the Addendum dated 30th October 2019, the payment of Rs. 55,62,833/- made on 17th October 2017 relates to service period 17th June 2017 to 31st August 2017. Thus, part of the payment relates to the services rendered by the lender’s legal counsel for period prior to the insolvency commencement date i.e. 26th July 2017 from the tagging account.

The RP, in spite of the Circular dated 12th June, 2018 clearly and unequivocally stating under para 8 clause (f) that the IRPC shall not include any expense incurred by a member of CoC or a professional engaged by the CoC, agreed with the CoC members, though conditionally, for payment of the fee of lender’s legal counsel which shows his disregard to the Circular issued by the Board. An IP is appointed to manage the stressed CD. It is not understood how he can appoint legal counsel for lenders that are independent bodies (creditors).

The conditional inclusion of the fee also indicates that the CoC members were not sure of inclusion of the same as part of IRPC cost. Further, the draft inspection report issued by the Board dated 2nd August 2018 had also pointed out that fees of the lender’s counsel should not be part of the IRPC. However, in the 19th CoC meeting dated 10th October 2018, the RP who is also the Chairman of the CoC meeting, despite being pointed out as a contravention by the Board, acceded to the proposal of CoC on the pretext that if the Board objects then the legal cost will be reimbursed by the lenders on a pro-rata basis.

This shows that there is understanding between CoC and RP to contravene a law and willingness to remedy the situation only if they are caught. Thus, the RP has deliberately compromised his independence.

The RP has further contended, through his counsel, that clause (e) to Regulation 31 of IBBI (Insolvency Resolution Process for Corporate Persons) Regulations 2016 provides ‘other costs directly relating to the corporate insolvency resolution process and approved by the committee’ can also form part of IRPC.

However, the contention of RP about including the fee of legal counsel of CoC in other costs of IRPC cannot be accepted as the fee paid to legal counsel of CoC, that are independent bodies, cannot be said to be directly related to the CIRP. Minutes of 3rd CoC meeting dated 31st October 2017 clearly states under the para 8 ‘
  • …The representative of xxxxx explained the members that in case the same (the fee of lender’s legal counsel) was to be borne by the lenders they in turn would file additional claims against the Company and the said would eventually be charged to the Company…’.
About filing of additional claims, it is pertinent to mention that claim amount is as on the CIRP commencement date (though lender’s counsel fee cannot be a part of claim). Expenditure incurred during CIRP by an RP cannot be claim amount. Thus, the RP permitted something unlawful because he was indemnified by parties who were interested in that unlawful action and the RP did this deliberately.

Findings of DC:
In view of admission by RP of having charged lender’s legal counsel (xxxxx) fee of Rs. 12,09,90,185/- from IRPC and specifically for the services rendered prior to the Insolvency Commencement date (i.e. period from 17th June 2017 to 25th July 2017) of CD, RP has contravened Section 208 (2) (a) of the Code and also Regulation 7(2)(a) and 7(2)(h) of the IBBI (Insolvency Professionals) Regulations, 2016 read with Clause 3 and 5 of the Code of Conduct as given in the First Schedule of the IBBI (Insolvency Professionals) Regulations, 2016.”

Author’s Comments;
Summing up;
  1. A total of the lender's legal counsel fee of Rs. 12.09,90,185/- was paid & charged to IRPC.
  2. Out of the above Rs.1,47,89,315/- has been paid to the lender's legal counsel for bills raised on 06.10.2017, 09.01.2018 and 07.03.2018 during CIRP, but prior to the issuance of Circular on ‘Fee and other Expenses incurred for CIRP’ dated 12th June 2018.
  3. Out of the above (2), the payment of Rs. 55,62,833/- made on 17th October 2017 relates to service period 17th June 2017 to 31st August 2017. Thus, part of the payment relates to the services rendered by the lender’s legal counsel for the period prior to the insolvency commencement date i.e. 26th July 2017. As per the provisions of the Code CoC is usually formed within 30 days of DOC. How come legal counsel of CoC was appointed prior to its formation?
  4. CoC, in its 3rd meeting on 31st October 2017, discussed the fees of xxxxx (lender’s legal counsel), it was clarified by representative of xxxxx (lender’s legal counsel) that the fee of legal counsel of CoC can be charged to CD as a general practice. The representative of xxxxx (lender’s legal counsel) should have clarified the provisions of the Code & Regulations, instead of giving vague advice of general practice.
  5. Despite RP citing his reservation, based on draft inspection report dated 02.08.2018, on the aspect of fees of lender’s legal counsel, in 18th CoC meeting, forming part of IRPC , CoC decided to route appointment of and payment to xxxxx (lender's legal counsel) through RP and on receipt of resolution plan, fees payable to lender’s legal counsel may be negotiated with resolution applicant. It was further decided that if the Board does not allow this arrangement, then the fee amount will be recovered on pro rata basis from upfront cash recovery amount to be paid to lenders. In the 19th CoC meeting held on 10th October 2018, the members passed a resolution to that effect.
  6. RP has deliberately compromised his independence under duress from CoC.
  7. RP by facilitating the payment of lender’s legal counsel’s fee & charging the same to IRPC "deliberately" made the assets (funds) of the corporate debtor beyond the reach of any person who was entitled to make a claim against the corporate debtor; and the intent is also clear from the understanding between CoC and RP to contravene a law and willingness to remedy the situation only if they are caught. Thus this transaction has all the attributes of fraudulent transactions.
Issues;
1. Independence of the working of the Resolution Professionals
. RP in the present case, despite his reservations, succumbed to the pressures of CoC, as he holds the post of RP at the will of CoC, which has the powers to replace RP without assigning any reasons [section 27]. To help RP to maintain its independence, following reforms in the conditions of appointments of RP are suggested;
i). The provisions of the replacement of RP under section 27, may provide for specifying the reasons for replacement in the concerned resolution of the CoC, subject to the approval of AA.
ii). Secondly in case CoC does not replace IRP with RP in the 1st meeting of CoC (section 22), IRP may be deemed to be appointed as RP.

2. Deficient regulatory control of the Board. In the instant case, regulatory control of the Board was found lacking on the following counts;
i). Board’s inspection of the resolution process failed to identify the fraudulent transaction during CIRP, may be due to;
(a) lack of professionalism & objectivity of the inspecting authority or;
(b) lack of processing of the inspection reports at the Board's back end office.

For appointment of inspecting authority Code provides as under;
- Section 218(1). ………..the Board thereunder, it may, at any time by an order in writing, direct any person or persons to act as an investigating authority to conduct an inspection or investigation of the insolvency professional agency or insolvency professional or an information utility.

However, under the regulations Board restricted the appointment of inspection / investigating authority, to the officers of the Board, who are usually not qualified professionals;
- Regulation 2;
- (e) “Investigating Authority” means an officer or a team of officers of the Board, which has been directed by the Board, to conduct the investigation of a service provider;
- (f) “Inspecting Authority” means an officer or a team of officers of the Board, which has been directed by the Board, to conduct the inspection of a service provider;
For objectivity & professionalism in the inspections, insolvency professionals should be associated alongwith officers of the Board, for inspections / investigations of the CIRP.

ii). In the instant case, the Board initiated action post facto. The Board, instead of taking post facto actions, should have some system to timely prevent such transactions. Secondly the Board is inspecting only in 15 to 20% cases, a large no. of irregularities may / can go unnoticed. To address both the issues it is suggested that the Board should have authority to appoint an independent insolvency professional as observer/non voting member in CoC, with rights to participate in the proceedings/discussion of CoC. This way, the Board will get regular and timely professional feedback on the working of RP & CoC.

3, Lack of professionalism in the working of the CoC. In the instant case, despite RP expressing reservations, CoC went ahead in passing resolution for payment of fees of the lender's legal counsel as IRPC. CoC further decided that if the Board does not allow this arrangement, then the fee amount will be recovered on a pro rata basis from upfront cash recovery amount to be paid to lenders.

Most of the financial creditors in CoC are banks. Banks being impersonal legal entities, usually appoint their employees as their authorised representative in CoC, who are not professionals and do not understand the insolvency ecosystem. Here the provisions of the Code are of quite significance.
# Section 24(5) Subject to sub-sections (6), (6A) and (6B) of section 21, any creditor who is a member of the committee of creditors may appoint an insolvency professional other than the resolution professional to represent such creditor in a meeting of the committee of creditors:
Provided that the fees payable to such insolvency professional representing any individual creditor will be borne by such creditor.

The main import of the Section 24(5) of the code is that a financial creditor can attend the meeting of CoC, through a representative who has to be an insolvency professional other than IRP/RP.

The appointment of IP’s as authorised representatives of the banks in CoC will definitely improve the working of the CoC & inculcate the professionalism in the decisions of the CoC. Secondly IP's are being regulated by the Board & IPA’s, their misconduct can be examined by the Board & IPA’s. It is suggested that the Board may make suitable provisions in the regulations and issue a circular on this aspect.

References;
1. Insolvency & Bankruptcy Code,2016.
2. Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016.
3. Insolvency and Bankruptcy Board of India (Inspection and Investigation) Regulations, 2017.
4. Insolvency and Bankruptcy Board of India (Insolvency Professionals) Regulations, 2016.
5. IBBI circular No. IBBI/IP/013/2018 dated 12th June, 2018
6. e-book "Offences & Penalties in IBC" by Arvind Mangla, a publication of Amazon Kindle Store.
7. Article - India: Avoidable Transactions Under The Insolvency And Bankruptcy Code: Key Considerations by Shahezad Kazi and Misha Chandna.

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.

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Arvind Mangla
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