The insolvency of Jaypee Infratech Limited (JIL) is only eclipsed by Essar Steel in its contribution to insolvency law. The very definition of a financial debt, the cornerstone of the IBC, was amended to fulfil the needs of its homebuyers, mostly the hapless purchasers of JIL’s aptly-named, graveyard-like “Wish Town” project. JIL’s latest offering to IBC enthusiasts comes in the form of a judgment delivered by the Supreme Court late last month.
The Court had to decide on two issues: (i) whether some of JIL’s mortgages of its properties to lenders of its parent company Jaiprakash Associates Limited (JAL) amounted to a “preference” under Section 43 of the IBC, and (ii) whether JAL’s lenders, to whom these mortgages were given, could be termed as financial creditors of JIL. In this blog piece, I intend to deal only with the Court’s treatment of question (i), leaving question (ii) for another post.
The stiff requirements to prove a preference
From the body of the judgment, it seems apparent that the assets of JIL had been dealt with only to benefit JAL, which held over 70% of its equity. 858 acres of land owned by JIL were mortgaged to various lenders to secure debt owed by JAL to them; this at a time when the accounts of JIL had already been declared to be non-performing assets. As per Sections 43 and 44, if a transaction carried out by the corporate debtor within a prescribed period before its insolvency commences is held to be a preferential transaction (or simply put, a “preference”), the transaction can be annulled.
The requirements of Section 43 are very specific, and appear to have been purposefully drafted in that way. After all, it is against the interests of the free flow of trade and commerce, upon which our economy rests, for any and every transaction entered into with a company before it is declared to be insolvent to be scrutinised by courts and annulled.
Section 43 does not apply to all transactions. It only applies to a transaction between the corporate debtor and one of its creditors (or its sureties or guarantors, but such cases are likely to be less frequent). This transaction should be such as to put the creditor in a more beneficial position than it would have been in the event of a distribution of assets of the corporate debtor being made as per the liquidation provisions of the IBC.
Not only this. The transaction has to have occurred in the recent past. For a transaction with a related party, this “look-back” period is two years, and for a transaction with anyone else it is a year.
Even a transaction which satisfies the requirements mentioned above would be excluded from being termed a preference is it is held to have been made in the ordinary course of the business of the corporate debtor, or if it creates a security interest in the property of the corporate debtor for money or its worth in goods or services.
JAL’s lenders’ arguments and the Supreme Court’s verdict
With these stringent statutory requirements, naturally the lenders of JAL, who opposed the declaration of their transactions with JAL and JIL as preferences, had plenty to argue. Unfortunately for them, the Supreme Court rejected each one of their arguments. As per the Supreme Court, JIL had given a preference to JAL, which together with being an equity holder of JIL was also a creditor.
The lenders to JAL relied on evidence that seemed to suggest that JIL had mortgaged its properties to secure loans given to JAL well before the look-back period, and these mortgages were only renewed in the look-back period. The Supreme Court refused to see the matter in this light: “… It obviously befalls on the mortgagor (sic.) to consider at the time of creating any fresh mortgage as [to] whether such a transaction is expedient and whether it should be entered into at all.”
Recognising that it was hard to argue that the mortgages were in the ordinary course of the business of JIL, the lenders relied on the fact that the section says that the transaction had to be in the ordinary course of the business of the corporate debtor or the transferee. Since the transaction was clearly in the ordinary course of the business of the lenders, the argument went, it could not be a preference. This was a good argument, but after a deep dive into the law of interpretation of statutes, the Court decided that the word “or” had to be read as “and”. This is clearly correct, and a reading of the relevant sub-section itself shows that the word “or” was used conjunctively and not disjunctively.
Of the other arguments proffered by the lenders, the one that I found the most convincing was the policy argument: it was one thing to annul preferences to related parties like JAL, which clearly benefited and jumped their place in the creditors’ line. But could such a thing be done at the cost of third parties like the lending banks? How were they to know, at the time that the mortgages were executed, that JIL was in financial distress? Moreover, if such drastic consequences were going to be visited upon lenders who accepted securities from the related parties of their debtors in exchange for extending credit, this was likely to have a devastating effect on the economy. Lenders would in future insist on securities being given only by the borrower, which in turn would reduce the flow of credit in the market. I think the Supreme Court handled this argument well, stating that it was the responsibility of the banks to assess the security they had taken and assure themselves that the third party whose security was being taken was not already in the red or likely to fail in dealing with its own indebtedness. I thought a little about that last argument, and how the Supreme Court ruled on it. The consequences of requiring banks to assess the credit-worthiness of third-party entities like JIL (that were merely giving securities for loans taken by others) would be to increase costs for the lending banks. These costs would in turn be passed on to the borrower, thus making it more expensive to get credit. However, consider the alternative. If the transaction was held to be valid and not a preference, the assets of JIL would be subject to the mortgages of the lending banks, thus reducing recoveries for the creditors of JIL. Unlike the lending banks, the thousands of creditors of JIL are an amorphous body which had no ability to prevent assets being removed from the company by management prior to JIL’s insolvency being declared. It is a hard question, but on balance, I think the Supreme Court got it right.
