Preferential Transactions: Applicability of the Doctrine of Alter Ego in the Judicial Approach

1. Introduction

The incorporation and implementation of Insolvency & Bankruptcy Code, 2016 in India was an important step in order to set up a legal framework governing corporate insolvency as well as financial failures. IBC, has brought all the different legislations governing different fraudulent acts and transactions under one branch.

The act of fraudulent transaction is one such concept which is now regulated by the IBC, though it has been there in the Companies Act, 1956 as well as 2013. The idea behind incorporation of the regulation on fraudulent transactions in the Code has been adopted from the UK Insolvency Act, 1986. While drafting the laws on Bankruptcy, the Bankruptcy Law Reform Committee had stated the importance of the existence of such a law which could regulate preferential transactions declaring such acts of defrauding creditors void. The committee also mentioned that the applicability of the provision should not be limited to a time period.

In India, the concept of fraudulent/preferential transaction was incorporated keeping in mind the object of such a Code which would maximize the value of assets, create a just environment for entrepreneurship and ensure fair distribution of assets among all the legitimate stakeholders . 

Preferential Transactions under the Code is explained as a transaction wherein a preferential value or special value is given by the Corporate Debtor as laid down in Section 43 (2) of the Insolvency and Bankruptcy Code, 2016. The regulations dealing with anything and everything related to preferential transactions can be traced from Section 43 to Section 44 of theCode.

The article further talks about the important concept of ‘Doctrine of Alter Ego’ which is still overlooked by the Indian Judiciary. The idea behind this doctrine is that it is an exception to the concept of a company being a separate legal entity which means that on application of this doctrine, the company and its directors would be a single entity. This particular doctrine has found its place in many of the precedents yet it is not explored as much as it should have been in landmark cases like Anuj Jain v. Axis Bank Ltd., which has been analysed in this particular article. 

2. Preferential Transactions: The Judicial Approach

2.1 Intent of the Legislature

The legal provisions relating to preferential transactions have been dealt in Sections 43 and 44 of the IBC. Under sub section (1) of section 43 of IBC where the liquidator or the resolution professional feels that the Corporate Debtor at any particular time has given preference in any transaction, he can apply to the Adjudicating Authority for avoidance of preferential transaction and seek an order in accordance to section 44 of the Code. 

As per the provisions of sub section (4) of section 43, it can be concluded that a preference shall be deemed to have been given at a particular time under these two circumstances- (i) When it is given to a related party (other than by reason only of being an employee), during the period of two years preceding the insolvency commencement date or (ii) When a preference is given to a person other than a related party during the period of one year preceding the insolvency commencement date. 

2.2 Way Forward: In the opinion of the Judiciary

In the case of Anuj Jain v. Axis Bank Ltd., an appeal was filed by the Interim Resolution Professional in the Hon’ble Supreme Court, challenging the order of NCLAT which had ruled that holding third-party mortgages created by Jaypee Infratech Limited (JIL) in favour of the lenders of Jaiprakash Associates Limited (JAL) as not preferential. The major issues before the Supreme Court was whether the transaction in question was a preferential transaction or not and if creditors taking third party security can be categorized as financial creditors within the meaning of sections 5 (7) and 5 (8) of the IBC., The Supreme Court set aside the order of the NCLAT and considered the transaction to be a preferential transaction. While considering the second issue, the Supreme Court held that third party security cannot be considered as a  ‘financial debt’. 

The Supreme Court in its ruling reaffirmed that the provision of Section 43 of IBC should be interpreted strictly and that “intent to prefer” or “element of fraud” is irrelevant for the purposes of such an analysis. While considering the transaction to be preferential, the Supreme Court took into account some facts: (i) the JIL Mortgage benefitted JAL, by allowing it to raise debt from the JAL Lenders (ii) since JAL was an existing creditor of JIL, therefore, such benefit to JAL was in respect of an ‘antecedent debt’ owned by JIL to JAL.

The case further refers to scope of ‘ordinary course of business.’ One of the key issues before the Court was to decide whether to consider JIL Mortgage as an excluded transaction on account of it being in the ordinary course of business of the transferee (herein, JAL lenders) or a transaction that has taken place even in the ordinary course of business of JIL. The Court came to the conclusion that a transfer can only be said to fall under Section 43(a) if it is in the ordinary course of business of both the corporate debtor and the transferee.

The Apex Court also stated that the intention behind formulating such a Code was to prevent any kind of preferential transaction so that the assets are justifiably liquidated therefore the exclusionary clause given in Section 43(3), “which pertains to the transfer being made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee” should not be read in its literal sense but a purposive interpretation should be applied and therefore the expression “or” should be readas “and” in order to maintain the balance between the provision and the intent of the legislature to protect the creditors by way of formulating this regulation.

2.3 Doctrine of Alter-Ego: The disregarded concept by the Judiciary

The term “Alter-Ego” in its literal sense means “Other I” which is derived from a Latin term. The elementary understanding of the corporate law in India denotes a company as a separate legal entity from its directors/owners. There are certain exceptions to this differentiation which is done for the greater good of the public at large and one such exception to this concept is the doctrine of alter ego which upon application narrows down the distinction between the company and its directors. This doctrine was discussed by the Supreme Court in Sunil Bharti Mittal v. Central Bureau of Investigationand various other precedents which considers the company and its directors should be treated as one single entity so that fraudulent transactions taking place behind the veil are discovered and justice is done for public welfare.

Furthermore, delving into the judgment it can be inferred that though the doctrine of alter ego hasn’t been discussed by the Court directly but its relevance in the case cannot be disregarded. The common notion suggests that a company is a separate legal entity in the eyes of the law but as previously mentioned, the doctrine of alter ego is an exception to the common notion. The doctrine would be invoked in cases involving fraudulent transactions, where there is a deliberate intent on the part of the debtor to give away its assets to or for the benefit of its alter ego. In the present case, the applicability/non applicability of alter ego plays a role as the two companies can be considered to be alter egos of each other as they share the relationship of a holding and a subsidiary company. However, neither the NCLT nor the NCLAT or the Supreme Court delved into discussing the application of the doctrine in-depth. With lack of judgments pertaining to the concept of alter ego, it becomes crucial for the Courts to discuss the doctrine which is necessary in order to provide clarity on the concept in the Indian regime. 

3. Conclusion

The judgment of the Supreme Court has paved the way for a better implementation of Section 43 of the Code and gave rise to a number of key factors for the stakeholders to keep in mind. It provides a clear picture so as to how resolution professionals and the adjudicating authority should apply the provisions of the code to evaluate preferential transactions. The concept of doctrine of alter ego has been enunciated in this article to reflect the importance of the doctrine in the IBC regime. The authors through this article suggest that the use of the doctrine while deliberating such relevant judgments is indispensable. 

[Divya Priyank & Komal Singh are Final-year students at NMIMS, Kirit P. Mehta School of Law, Mumbai. They can be contacted at divyapriyank03@gmail.com.]