Preferential Transactions Under IBC
Table of Contents
In insolvency law, a preferential transaction is a transfer of property or interest by a corporate debtor to a creditor, surety, or guarantor that occurs during a financially distressed period. A transaction is considered preferential if it places the creditor, surety, or guarantor in a better position than they would have been under the pari passu distribution of assets outlined in Section 53 of the Insolvency and Bankruptcy Code, 2016 (IBC). The key elements are that the transfer is made in relation to an antecedent debt (a prior liability) and occurs within a relevant lookback period—one year for unrelated parties and two years for related parties. This concept is statutory recognized under Section 43(2) of the IBC, which allows the resolution professional or liquidator to seek to avoid such transactions in order to ensure fair and equitable distribution among all creditors.
Legal Framework Governing Preferential Transactions Under IBC
A preferential transaction is defined in Section 43 of the IBC as one in which a corporate debtor transfers property or an interest in property to the benefit of a creditor, surety, or guarantor in order to discharge an antecedent debt, resulting in that party receiving more than they would have under Section 53’s liquidation waterfall mechanism. To qualify as preferential, a transaction must meet two conditions: (1) the transfer must be for an antecedent debt, and (2) the recipient must be in a better position than they would have been in liquidation. The relevant time for assessing preference is one year for unrelated parties and two years for related parties, according to Section 43(4). Certain transactions, however, are exempt from being considered preferential.Section 44 empowers the Adjudicating Authority, the National Company Law Tribunal (NCLT), to declare such transactions void and order their reversal, including benefit recovery, to ensure equitable distribution among all creditors.
The Insolvency and Bankruptcy Board of India (IBBI) regulates insolvency professionals, processes, and entities, ensuring compliance with the IBC and upholding the integrity of insolvency resolution and liquidation procedures. IBBI creates and enforces regulations, such as the Insolvency Resolution Process for Corporate Persons Regulations of 2016, which establish timelines, procedures, and responsibilities for Resolution Professionals (RPs) and Liquidators. To ensure asset value maximization, the RP or Liquidator must scrutinize transactions dating back up to two years from the insolvency commencement date (ICD), identifying preferential, undervalued, or fraudulent transactions, particularly those involving related parties or benefiting creditors. RPs and Liquidators must submit reports, applications, and determinations to the NCLT within specified time frames, including Form H for avoidance transactions, and ensure complete compliance with the Code and IBBI regulations. IBBI essentially supervises the actions of RPs and Liquidators, has the authority to impose disciplinary action for noncompliance (for example, failure to report undervalued transactions), and ensures professional standards are met through regulatory frameworks and periodic reviews.
Read more : Undervalued Transactions under IBC
Essential Ingredients of a Preferential Transaction (Section 43 Test)
- A preferential transaction requires the transfer of the corporate debtor’s property or interest in it to a creditor, surety, or guarantor.
- The recipient must be a creditor, surety, or guarantor for or on behalf of the corporate debtor’s previous financial, operational, or other liabilities.
- The transfer must result in the beneficiary being in a better position than they would have been if assets had been distributed in accordance with Section 53 of the International Business Code.
- The transaction must have taken place within two years of the ICD if the beneficiary is a related party, or within one year if the beneficiary is unrelated.
Look-Back Period for Preferential Transactions
Preferential Transactions under the IBC have different look-back periods depending on the relationship between the corporate debtor and the recipient of the transaction. The look-back period for transactions involving related parties is two years prior to the ICD, whereas it is one year for unrelated parties. This period is calculated from the insolvency commencement date, not the date the IBC went into effect, ensuring retrospective scrutiny of potentially harmful transactions. The timing is critical because any preferential transaction occurring during these times can be challenged and set aside by the resolution professional or liquidator to protect the interests of all creditors. Thus, timing has a direct impact on the validity of avoidance applications, making precise calculation of the look-back period critical for legal strategy and recovery efforts.
Exclusions from Preferential Transactions
- Transactions made in the ordinary course of business, transfers creating security interests for new value, and certain commercially justified transactions are all not considered preferential under Section 43(3) of the IBC.
- A transfer is not considered preferential if it occurs in the ordinary course of business or financial affairs of either the corporate debtor or the transferee, as long as it is genuine, commercially justified, and does not undermine the collective insolvency process.
- A transfer that creates a security interest in property acquired by the corporate debtor is excluded if the security interest secures new value, was granted at or after the signing of a security agreement, and was used by the corporate debtor to acquire the property, with registration within 30 days of possession.
- Transactions with a legitimate business purpose, such as maintaining the corporate debtor’s going concern value, may be excluded.
- Once a preferential transaction is presumed under Section 43(2), the transferee must prove that the transaction meets one of the exceptions, such as being in the ordinary course of business or securing new value.
Preferential Transactions vs Other Avoidance Transactions
Preferential transactions involve transferring assets to a creditor, guarantor, or surety in exchange for an antecedent debt, putting them in a better position than if liquidated. Other avoidance transactions include undervalued (assets transferred below fair value), extortionate credit (unfair credit terms), and fraudulent (defrauding creditors) transactions. All are set aside to protect creditors’ collective interests and ensure an equitable distribution of assets. The differences between these transactions and preferential transactions are given below:
- Preferential vs undervalued transactions: A preferential transaction benefits a creditor by improving their recovery position in comparison to other creditors, and is frequently used to resolve antecedent debts. An undervalued transaction occurs when assets are transferred for a price significantly below market value, without necessarily benefiting a specific creditor. The main distinction is in the purpose: preferential transactions benefit a creditor’s claim, whereas undervalued transactions focus on asset devaluation.
- Preferential vs extortionate credit transactions: Preferential transactions involve the transfer of assets to a creditor in order to increase their recovery. Extortionate credit transactions involve obtaining credit on exorbitant or unconscionable terms, with the debtor paying excessive interest or collateral. The former concerns asset transfer, while the latter concerns unfair credit conditions, both of which are designed to protect the estate from unfair advantage.
- Preferential vs fraudulent transactions: Preferential transactions are evaluated based on timing and benefit to a creditor, without requiring proof of intent. Fraudulent transactions require a clear intent to defraud creditors, which frequently involves concealment or deliberate asset stripping. The distinction is based on intent: absence in preferential cases; presence in fraudulent ones.
- Effect-based vs intent-based analysis: Effect-based analysis (used in preferential, undervalued, and extortionate transactions) examines whether the transaction harmed creditors’ collective recovery. Intent-based analysis is only applicable to fraudulent transactions and requires proof that the debtor acted with fraudulent intent. Courts are increasingly looking at the underlying spirit and intent of avoidance provisions, particularly in complex cases, to prevent abuse.
Role of Resolution Professional in Identifying Preferential Transactions
The RP is responsible for scrutinizing transactions made by the corporate debtor within a specified period before insolvency commencement to identify any preferential transfers that may have unfairly benefited certain creditors, thus undermining the principle of pari passu distribution under the IBC.
- The RP examines the corporate debtor’s books of accounts, financial records, and bank statements to trace the flow of funds, verify antecedent debts, and determine whether transactions meet the criteria for preferential classification under Section 43(2) of the IBC.
- The RP conducts transactional and forensic audits to detect irregularities, analyze patterns of financial behavior, and collect admissible evidence—such as round-tripping, fictitious vendor transactions, or unusual payments—that may indicate preferential or fraudulent transfers.
- The RP forms an objective opinion based on factual evidence gathered through forensic analysis to determine whether a transaction qualifies as preferential under the IBC, without expressing personal opinion and instead relying on legal standards and judicial precedent.
- The RP submits its findings, including the identification and quantification of preferential transactions, to the Committee of Creditors (CoC) for consideration during the insolvency resolution process, ensuring transparency and informed decision-making.
Filing Application for Avoidance of Preferential Transactions
- An application for avoidance of preferential transactions under Section 43 of the IBC must be filed by the RP or the Liquidator, as only they have the legal authority to initiate such proceedings.
- The application must be filed with the relevant bench of the NCLT, which has jurisdiction over the insolvency proceedings.
- Only the RP or the Liquidator may file an application under Section 43; no other entity, including creditors, homebuyers, or corporate debtors, is permitted to do so.
- The RP must provide evidence that the transaction involved a transfer of property or interest, was made to satisfy an antecedent debt, benefited a creditor/surety/guarantor, and placed them in a better position than they would have been under the pari passu distribution under Section 53 of the IBC.
Powers of NCLT in Preferential Transaction Cases
- Under Section 44 of the IBC, the NCLT has the authority to set aside preferential transactions and issue consequential orders on the application of the resolution professional or liquidator.
- If a transaction is found to be a preferential transaction under Section 43, the NCLT may declare it void and order its reversal, provided that the conditions in Sections 43(2) and (4) are met and the transaction is not excluded.
- The NCLT may order that property transferred in a preferential transaction be vested back in the corporate debtor, ensuring that the asset is returned to the insolvency estate for equitable distribution among all creditors.
- The NCLT may require the beneficiary of a preferential transaction to repay the value received, including proceeds from the sale of transferred property, to the liquidator or resolution professional.
- The NCLT has the authority to grant additional reliefs such as discharging security interests, restoring guarantor liabilities, requiring new security, and determining proof of claims, all in order to ensure creditors are treated fairly and equitable.
Preferential Transactions in Liquidation
The liquidator is responsible for identifying and pursuing preferential transactions during liquidation, as required by Section 43 of the IBC, in order to recover assets that have been transferred unfairly to creditors. The liquidator must examine transactions from the insolvency commencement date backward, particularly those made within one year for unrelated parties and two years for related parties, to determine whether they constitute preferential transfers. Even after the liquidation order is issued, avoidance proceedings can continue post-liquidation because the NCLT retains jurisdiction to decide such applications, ensuring that recovery efforts are not hampered by the liquidation process. Any amounts recovered through avoidance actions become part of the liquidation estate and are distributed to creditors in accordance with the waterfall mechanism outlined in Section 53 of the IBC, ensuring equitable and priority-based distribution. This process protects the collective interests of all creditors and maximizes recovery from previously unduly transferred assets.
Judicial Principles on Preferential Transactions Under IBC
- Courts emphasize that a transaction must strictly meet the criteria under Section 43 to be considered preferential, with a focus on whether it benefits a creditor for a prior debt. The judiciary maintains that these provisions are objective and effect-based, which means that the outcome of the transaction is more important than the parties’ subjective intent. As a result, if a transaction meets the statutory definition, it is invalid, regardless of whether there was fraudulent intent.
- Courts take a substance-over-form approach, looking beyond a deal’s legal labeling to determine its true economic impact on the corporate debtor’s estate. For example, a mortgage created by a subsidiary to secure a parent company’s loan may be reclassified as a preference if it effectively depletes the subsidiary’s assets in order to favor specific lenders. This approach ensures that sophisticated legal structures cannot be used to get around the spirit of insolvency laws.
- A transaction is only actionable if it takes place within the specified “look-back period”—typically two years for related parties and one year for others. The primary judicial test is whether the transfer placed a creditor in a better position than they would have been under the standard liquidation waterfall. This temporal and impact-based filter ensures that only actions that disrupt the insolvency process are reversed.
- The judiciary sees the avoidance of preferences as a tool for upholding the principle of pari passu, which ensures that assets are fairly distributed. By canceling these transactions, courts prevent “race to the courthouse” behavior, in which one creditor recovers at the expense of the group. This focus protects the integrity of the liquidation framework and ensures that the resolution process is fair to all stakeholders.
Practical Implications for Insolvency Professionals and Creditors
IPs play an important role in managing the corporate debtor’s affairs, preserving asset value, and ensuring compliance, and their performance has a direct impact on resolution timelines and recovery outcomes:
- The success of CIRP is dependent on their collective decision-making through the CoC, where voting thresholds determine plan approval, which directly influences recovery rates and resolution value.
- Recovery from avoidance transactions, such as preferential or fraudulent transfers, can increase creditor recoveries by at least 10% and improve overall resolution value.
- Promoters frequently oppose CIRP in order to maintain control; however, Section 29A of the IBC prohibits them from becoming resolution applicants, and avoidance proceedings aid in the recovery of assets misappropriated prior to insolvency.
- The timely initiation and adjudication of avoidance proceedings is critical for preventing value erosion, ensuring equitable distribution, and maintaining the integrity of the resolution process.
- While avoidance litigation is time-consuming and expensive, the long-term benefits—such as recovering substantial assets and improving creditor recovery rates—make it worthwhile, particularly in high-value cases involving significant undervalued or preferential transactions.
Common Mistakes and Misconceptions About Preferential Transactions
- Not all pre-insolvency repayments are preferential transactions; only those that benefit a specific creditor disproportionately and occur during the look-back period (one year for unrelated parties, two years for related parties) are subject to avoidance.
- Transactions in the ordinary course of business or those that add new value to the corporate debtor are not treated as preferential, even if they occur during the relevant look-back period.
- A preferential transaction gives a creditor an unfair advantage without the intent to defraud, whereas fraudulent transfers require actual intent to hinder or delay creditors, making the two legally distinct under the IBC.
- The RP must file an application for avoidance of preferential transactions on or before the 135th day of the CIRP, and delays can jeopardize asset recovery and undermine the insolvency proceedings.
Why Avoidance of Preferential Transactions is Central to IBC
- Avoidance of these transactions is critical to IBC because it prevents a corporate debtor from selectively repaying certain creditors just before insolvency, undermining the fairness of the resolution process.
- It ensures fair treatment of creditors by invalidating transactions that put specific creditors in a better position than they would have been under the IBC’s waterfall mechanism.
- It protects the value of the insolvency estate by recovering assets that were unfairly transferred, thereby increasing the pool available for distribution to all creditors.
- It boosts creditor confidence in the IBC by reiterating the principle that all creditors will be treated fairly and uniformly during insolvency proceedings.
Practical Insights for Insolvency Aspirants
- To effectively structure Section 43 answers, first identify the four key ingredients of a preferential transaction: (1) transfer of property or interest, (2) for the benefit of a creditor/surety/guarantor, (3) in relation to an antecedent debt, and (4) placing the beneficiary in a better position than liquidation. Use statutory references, such as Sections 43(1) and (2), to anchor each point and ensure alignment with the Supreme Court’s framework in the Anuj Jain case.
- Before concluding that a transaction is preferential, always check to see if it satisfies all four ingredients—if any are missing, it is not preferential. Apply Section 43(3) exclusions: a transaction is not preferential if it occurred in the ordinary course of business of both the corporate debtor and the transferee, according to a narrow interpretation upheld by the Supreme Court.
- Map factual scenarios directly to statutory language—for example, a mortgage to a holding company must be scrutinized under Section 43(3) and the Anuj Jain test, rather than being assumed exempt. Use the term “legal fiction” from Section 43(2) to emphasize that intent is irrelevant in preferential claims, as opposed to fraudulent transactions under Section 66.
- Do not assume that related party status alone makes a transaction preferable; context is important. A transaction with a related party may be considered ordinary course of business if both parties engage in such activity on a regular basis.
FAQs – Preferential Transactions Under IBC
Section 43 of the IBC does not require intent to prove a preferential transaction because the provision functions as a deeming fiction—if the conditions in Sections 43(2) and (4) are met, the transaction is deemed preferential regardless of intention.
No, loan repayment is not always considered preferential; it is only considered preferential if it occurred during the look-back period (one year for unrelated parties, two years for related parties) and resulted in the creditor being in a better position than other creditors in liquidation.
Section 43 of the IBC allows the Resolution Professional or Liquidator to file an application to avoid preferential transactions.
Yes, preferential transactions are applicable during liquidation, as the liquidator has the authority to challenge and avoid such transactions to ensure equitable distribution of assets among creditors.
If a transaction is held to be preferential, the Adjudicating Authority (the NCLT) may order the return of the benefit conferred, typically requiring the recipient to refund the amount to the Corporate Debtor’s estate.
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