Fraudulent Transfers in Insolvency

Insolvency proceedings are a process which deals with imminent bankruptcy of a debtor in one of the methods set forth by the insolvency legislation in order to settle the financial relations between the indebted company and its creditors and to satisfy the creditors’ claims to the maximum possible extent. Corporate insolvency is one of the most conspicuous provisions in the Indian corporate scenario, more so because the Indian judiciary is notoriously tilted towards attempting to revive a “sick” company than allowing it to be shut down altogether. In itself corporate insolvency finds mention in the Companies Act, booth the 1956 as well as the later 2014 versions. In addition corporate insolvency finds its place in the provisions of the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) this is currently incorporated into the current amended Companies Act, the Recovery of Debts due to Banks and Financial Institutions Act, 1993 (RDDB Act). The related legislations are ‘The Transfer of Property Act, 1882, and ‘The Securities and Exchange Board of India Act 1992. The Companies Act has since seen as many an amendment. Some of the major amendments to the Act were made through Companies (amendment) Act of 1988 on the recommendations of Sachar Committee and then again in 1998, 2000 and finally in 2002 though the Companies (Second Amendment) Act of 2002 as a consequence of Eradi Committee Report.[1] The Eradi committee was set up by the Government of India in 1999 and was headed by Justice Eradi – a retired judge from the Supreme Court of India.[2] In the budget speech read out by the current Hon’ble Finance Minister Shri Arun Jaitley he has bemoaned that the SICA and the BIFR have not been very effective; thus he has proposed the bringing into force of a Bankruptcy Bill that will have global standards for bankruptcy proceedings and better proviosions for accountability in such bankruptcy cases.

Insolvency is said to occur in case an individual, corporation, or any other institution cannot honour the monetary obligations that it has incurred, particularly for clearing debts as and when they become due. Insolvency may also take place in the case of certain exigencies realizing themselves, some of which may be said to be the result, direct or indirect, of poor cash management, increase in cash expenses, or decrease in cash flow. A true and proper finding of this insolvency is very essential, as this enables specific rights that may be accrued to the creditor to be exercised against the insolvent individual or organization. For example, outstanding debts may be paid off by liquidating assets of the insolvent party. Prior to proceedings, it is common for the insolvent entity to meet with the creditor in order to attempt to arrange an alternative payment method.

Thus it is very clear that what is of essence in cases of insolvency is the payment of outstanding dues. Under the Companies Act 1956, there is section 433 (e) which anticipates a situation in which a company is unable to pay off its debts and thus is deemed to be insolvent and ordered to be wound up by the court. There might be situations where a company is cash-poor but asset-rich, the opposite scenario may be true too, ie, a company is cash-rich yet asset-poor. In any case, it may be assumed that the company is in a position to pay off its debts. However, in this research project the researcher shall concentrate on insolvent companies, implying companies which are not in a position to pay off its debts fully.

In this project, the researcher shall essentially deal with the process of insolvency and the transfer of assets that takes place during insolvency, particularly the fraudulent tarsnfers that may take place therein.

Research questions

In this research, the researcher shall proceed on the basis of the following research questions:

1. What constitutes fraudulent transfers in insolvency?

2. What are the consequences of such transfer?

3. How to prevent such fraudulent transfers?

4. Who may be held responsible for such fraudulent transfers?

What constitutes fraudulent transfers in insolvency?

In general, the following situations may be said to give rise to an assumption of a fraud having been committed during winding up of an insolvent company:

1. Falsification of documents;

2. Transactions in fraud of creditors;

3. Misconduct in the course of winding up. [3]

Under the provisions of section 326 of Companies Act, 2013 in the winding up of a company, the debts shall have to be paid in the following order:

i. Workmen’s dues, which shall include:

a. All wages and remuneration due to the workmen;

b. All accrued holiday remuneration of the workmen;

c. All amount that may be due to the workmen in case of any compensation being sue to the workmen;

d. all sums due to any workman from the provident fund, the pension fund, the gratuity fund or any other fund for the welfare of the workmen, maintained by the company;

ii. all debts due to the secured creditors, however as per clause (iii) of the proviso (1) to section 325 of the Companies Act 2013, such debt shall again be subject to a pari passu charge in favour of the workmen on such debt. [4]

Thus under the companies law regime in India the creditors do not have a preferential right over the assets of the company when it comes to the liquidation of a company. In the opinion of the researcher this is a rather unfortunate provision as this may act towards making potential creditors disinterested in investing in any company. In general a transfer may raise the whiff of fraudulence if it breaches against the order set out by law or by bypassing a party altogether.

Fraudulent transfers may again be broadly categorized into two types:

i. Actual fraud;

ii. Constructive fraud.[5]

An actual fraud is said to occur when the fraud is apparent on the face of it, ie, by a bare perusal of the fraud it is very easily comprehensible that there has been a fraud in the transfer. A constructive fraud I said to occur in the following cases:

a. Receives less than the reasonable value of the item in exchange for the transfer;

b. Cannot pay debts either at the time the transfer was made or as a result of it.

Insolvency fraud is little-known yet it is a very topical “white collar” fraud type. It includes concealment and illegal transfers of assets from a company, conflict of interest, fictitious claims, falsification, concealment and destruction of documentation and financial statement fraud. Asset concealment is a very common form of insolvency fraud wherein company representatives attempt to conceal, hide and falsify asset documentation so that rather than being registered to the estate, the assets can be transferred to related parties. These company assets might include not only tangible assets such as cars, machines, land or equipment, but also intangible ones such as technology, patents and know-how.[6]

Fraudulent transfer may also take place prior to or in the initial stages of the insolvency proceedings. Some of the ways through which this is actuated are selling products with large discounts just before the bankruptcy via shell companies; assignment of receivables to an off-shore and non-transparent company; selling of debtor’s stake in its profitable subsidiary company for a disadvantageous price; accepting of liabilities of related companies without any remuneration; closing of a long-term rental contract (e.g. 20 years) and pay it up-front; discontinuing of payments for leased property just a few installments before the end of the lease contracts, the equipment is later sold to a firm related to the debtor.[7]

Practices that may be construed as fraudulent during the continuation of the insolvency proceedings include employing ghost employees (related to the insolvency trustee or company owners); providing hidden loans to a related entity; falsifying of official reporting to insolvency trustee, creditors’ committee and the insolvency court to conceal e.g. personal expenses; paying of salaries, concealed as a business transaction with a third party (related); renting of equipment from the related company for overstated prices; incorporating of a new trade entity (no property, all services are provided from the debtor) and transferring of the debtor’s portfolio of customers to the entity. [8]

Prior to the commencement of the Companies Act, 2013 whenever a company was declared bankrupt al the functioning of the company would stop immediately, as if it went into a coma, but now the current Companies Act 2013 has provided for a staggered approach in case of winding up of an insolvent company, thus providing for a balanced and beneficial winding up of such a company.

What are the consequences of such transfer?

In the United Kingdom the consequences of such fraudulent transfers tend to be both civil and criminal in nature. The criminal reprisals include fine which may be of an unlimited strength, such unlimited strength is specified mainly to act as a punitive trait and deter those that may be held accountable to prevent abusing their powers and positions. Another criminal punishment may be imprisonment for up to 7 years. Civil consequences too are of two types the first being unlimited personal contribution to the assets of the company, subject to the discretion of the court. In a way this shall act as a means for asking those that were responsible to pay for what has happened. Such unlimited personal contribution may not only be compensatory but also punitive. The second punishment may be disqualification for the persons responsible for such transfer from holding any position in any company for a period of 15 years from the date of the award of the court.

In India, once insolvency is declared, an officer appointed by the court, known as official liquidator comes into play and he has to oversee the whole of the liquidation proceeding of the insolvent company. Thus in such cases where the liquidator gets to know of such fraudulent transfers, he is very much empowered to annul such transfers to mitigate the harm that may have been caused by such transfer. In general in India, once insolvency is declared it is the official liquidator that has to take over the general administration of the company in liquidation. In general the company liquidator shall have the power of:

(i)taking over assets; (ii) examination of the statement of affairs; (iii) recovery of property, cash or any other assets of the company including benefits derived therefrom; (iv) review of audit reports and accounts of the company; (v) sale of assets; (vi) finalization of list of creditors and contributories; (vii) compromise, abandonment and settlement of claims; (viii) payment of dividends, if any; and (ix) any other function, as the Tribunal may direct from time to time.[9]

The greatest feature of the Companies Act, 2013 that may be said to deal with the consequences of any fraudulent transfers in the winding up (or in any matter) of the company, may be found in section 282 of the Companies Act, 2013. As per sub-section (3) of section 282 of the Companies Act, 2013, whenever a report is received from the Company Liquidator or the Central Government or any other person that a fraud has been committed in respect of the company, the Tribunal shall, without prejudice to the process of winding up, order for investigation under section 210, and on consideration of the report of such investigation it may pass order and give directions under sections 339 to 342 or direct the Company Liquidator to file a criminal complaint against persons who were involved in the commission of fraud.

Under section 210 the central government is empowered to conduct investigations into the affairs of a company.

By virtue of the provisions of the Companies Act 2013, the directors of a company have been given specific duties to perform unlike the 1956 legislation which concentrated mainly on the fiduciary role of the directors. Under the 2013 act it has been specifically laid down as to what documents and reports the directors have to compulsorily sign so that ultimately they cannot escape liability when the harm is done.

Once it's determined a transfer is fraudulent, the trustee can recover the property, or its value, and add it to the bankruptcy estate. An exception to this rule is when there is a bona fide purchaser. This is someone who acts in good faith to buy property without knowledge of the rights or claims of others. The bona fide purchaser can keep the property. Another exception is made in a case where valuable improvements are made to property. State laws give those who do the work, such as contractors, a lien on the property to secure payment.

How to prevent such fraudulent transfers?

The greatest and the best way to prevent such fraudulent transfers is obviously to keep on a constant monitor on such proceedings. Obviously it would be better to nip such problems in the bud by concentrating on strong and robust corporate governance within the company itself to avoid the possibility of the company being declared insolvent in the first place.

Due to the advent of the new Companies Act 2013 several key and useful provisions have been envisioned that help prevent such fraudulent transfers. As already stipulated any person may complain to the central government against any company regarding any transaction that may have been undertaken fraudulently. Under the company court rules, 1959 any money received by the company liquidator during the winding up process must be deposited by the official liquidator into the Reserve Bank of India for in an account maintained specifically for this purpose.

In general courts in India are known for being heavily bent towards not allowing the winding up of a company, the courts in India always try and revive the company by recourse to various legislations. However, in the case of a winding up of a company, the official liquidator, who also acts as the company liquidator has to oversee the winding up process. In such cases, ie in acse of a company being wound up due to insolvency the company liquidator appointed is always from a databank maintained by the central government. According to section 275 of the Companies Act, 2013 “the provisional liquidator or the Company Liquidator, as the case may be, shall be appointed from a panel maintained by the Central Government consisting of the names of chartered accountants, advocates, company secretaries, cost accountants or firms or bodies corporate having such chartered accountants, advocates, company secretaries, cost accountants and such other professionals as may be notified by the Central Government or from a firm or a body corporate of persons having a combination of such professionals as may be prescribed and having at least ten years’ experience in company matters.”

Creditors can ask the court for help when they suspect a debtor will make a fraudulent transfer of property. The court can issue a temporary restraining order and a preliminary injunction, ordering the debtor not to make the transfer.[10]

Who shall be responsible for such fraudulent transfers?

The simplest answer to this question may be said that the person upon whom the responsibility of such transfer devolves after the investigation conducted by the central government may be said to be responsible for such fraudulent transfer. In general as per the provisions of the Companies Act, it is the liquidator who assumes all powers of the general administration for the company during the winding up process to ensure that such process is carried off beneficially for all the stakeholders concerned. Thus, in case any discrepancy is found in the transfer related to such winding up it is the company liquidator who may be held to account.

By virtue of the doctrine of lifting of the corporate veil, if, in the course of winding up, it appears that any business of the company has been carried on with an intent to defraud the creditors of the company or any other person, or for any fraudulent purpose, the persons who were knowingly parties to the carrying on of the business in such fraudulent manner shall be personally responsible without any limitation of liability, for all or any of the debts or other liabilities of the company as the court may direct. Thus the reach of fraudulent transfers and the imposition of liability thereon extend even to pre-winding up transactions by virtue of the provisions of the Companies Act.

However, the position of the official liquidator is a dynamic one, it has undergone many changes over the course of innumerable judicial decisions. In the case of United Bank of India v. Official Liquidator,[ (1994) 1 SCC 575], the Court held that when the OL sells any property of the company, he “cannot and does not hold out any guarantee or warranty” and in particular he offers no warranty of title.” The administrator keeps in to his custody all the money received in the name of the company. However, he does not become the owner of such money, only the custodian. The administrator may also use the register of the company. The salary payable to the administrator is not a charge on the company’s assets, and his salary is borne by the central government.

Conclusion

The insolvency proceedings adopted in India are very long drawn and protracted ones. Through the new legislation in the form of the Companies Act 2013 the Indian law makers have opted for a staggered approach for the winding up of an insolvent company. The need for this approach was felt because under the previous legislative provisions whenever a company was decreed as insolvent and ordered to be wound up, all the activities of the company would come to a complete halt; the employees would stop working in anticipation of the company being closed down, to prevent this in the new Companies Act of 2013 has provided for a clear cut staged approach to ensure that the activities of the company continue for the benefit of all the stakeholders involved in the company and to ensure that the maximum returns may be received from the company. The new regime has also provided for clear cut division of powers of each stakeholder involved in the winding up process such as the company liquidator, the directors, etc. The new law also provides for the imposition of liability and provides for proper accountability in case of any malfeasance or misdemeanor.

However, the flip side of such an elaborate and elongated process is that the entire process takes unduly long to be finished, the process has been unnecessarily been rendered protracted and elongated. Insolvency proceedings in general take several years to be completed and they take more than their fair share time to be completed in India. In such circumstances it becomes very difficult to efficiently monitor the process throughout its life. However, the fresh Companies Act 2013 has been hailed as heralding into the corporate regime in India much needed changes to keep it at pace with the current global corporate practices. It would be wrong to tell it off at such a halcyon stage of its implementation. It can only be assumed that by a proper and vigorous perusal of the provisions of this act, the corporate regime of India will certainly turn out to be globally very competitive.

[1] Deepti Kanojia, Meenakshi, 'Insolvency Law in India with Special Reference to Corporate Insolvency' [2014]

International Journal of Trade and Commerce, 1, 1

[2] Ibid

[3] , 'An Introduction To Corporate Regulation and Standardization' (Practitioner.Com ) <http://legal.practitioner.com/regulation/standards_9_3_13.htm> accessed on 30/01/2022

[4] Companies Act, Section 326

[5] Supra 3

[6] 'Bankruptcy Fraud' (Surveilligence 2011) <http://www.surveilligence.com/en/services/fraud-detection/bankruptcy-fraud.html> accessed on 30/01/2022

[7] Ing. Ján Lalka, CFE Surveilligence, s.r.o., 'Insolvency fraud as one of the factors affecting recovery rates in insolvency proceedings' e.g. AL 1, 8

[8] Ibid

[9] Companies Act, 2013 Section 277(5)

[10] 'Fraudulent Transfers in Bankruptcy' (Lawyers.com 2015) <http://bankruptcy.lawyers.com/bankruptcy-basics/fraudulent-transfers-in-bankruptcy.html> accessed on 30/01/2022