Third-Party Funding as Catalyst for Effective Avoidance Recoveries under IBC
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Corporate debtors undergoing insolvency proceedings often face severe financial distress due to insufficient assets, making it extremely difficult to fund litigation, like avoidance proceedings, which are critical for recovering assets and maximizing their asset value. The lack of funds creates a significant barrier, as traditional financing is typically unavailable or too risky for creditors during insolvency. In such situations, a mechanism can be used known as Third-Party Funding (TPF). TPF addresses this challenge by providing non-recourse capital to insolvency professionals (IPs) or liquidators, enabling them to pursue recovery actions and legal claims against prior fraudulent or preferential transactions without bearing the upfront financial burden. This blog acts as a catalyst for effective Avoidance Recoveries under IBC by enabling resolution professionals (RPs) to pursue valuable but costly avoidance claims, thereby enhancing overall creditor recovery rates.
Understanding Third-Party Funding
TPF is an arrangement where an external, non-party investor finances the legal costs of a dispute in exchange for a share of the recovery proceeds if the case is successful. This funding is provided on a non-recourse basis, meaning the funder bears the risk of losses if the claim fails and does not recover their investment. In insolvency cases, where a corporate debtor undergoing the corporate insolvency resolution process (CIRP) faces severe financial distress and lacks funds, TPF is particularly relevant as it provides essential liquidity. It enables the RP to cover operational costs, pursue Avoidance Recoveries under IBC proceedings, and manage legal expenses critical to preserving the company’s assets and maximising recovery value.
Legal Recognition of Third-Party Funding in India
Indian law does not prohibit TPF for litigation, as confirmed by the Supreme Court in Bar Council of India v. A.K. Balajji, which clarified that there is no restriction on non-lawyers funding litigation and being repaid from the outcome. This recognition has been reinforced by various High Courts, which upheld the legality of such arrangement. The decision affirms that TPF is legally permissible, provided it does not involve lawyers and is not contrary to public policy. The IBC and its regulations do not expressly mention the use of TPF in insolvency proceedings. However, several orders from the National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) have approved the use of TPF, recognising its role in facilitating the resolution process. For instance, Regulation 39B of the Insolvency Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons Regulations, 2016 (CIRP Regulations) allows the Committee of Creditors (CoC) to estimate liquidation costs and the value of available liquid assets, and approve a resolution plan that includes contributions to cover any shortfall, thereby ensuring funds are available for recovery efforts. Regulation 39C empowers the CoC to recommend the sale of the corporate debtor or its business as a going concern, which can enhance recovery value, and Regulation 39D enables the CoC, consultation with the RP, to fix the liquidator’s fee, directly impacting the funds allocated for liquidation and recovery.
What Are Avoidance Transactions under the IBC?
Avoidance transactions are financial dealings undertaken by a corporate debtor before insolvency that unfairly deplete its assets, harming the collective interest of creditors and undermining the goal of equitable asset distribution. These include preferential transactions under section 43, where a creditor is given an advantage over others, undervalued transactions under section 45, involving asset transfers for significantly less than market value, extortionate credit transactions under section 50, characterized by unconscionably high interest or charges, and fraudulent or wrongful trading under section 66, which address the intentional fraud or continued operations with no reasonable prospect of avoiding insolvency. Pursuing these cases requires resources and time, making TPF a valuable enabler for recovery optimization.
Why Third-Party Funding is Relevant for Avoidance Recoveries under IBC
RPs and liquidators often have limited financial resources as their fees and expenses are paid from the corporate debtor’s estate, which is stressed or lacking sufficient cash. TPF can fund legal proceedings against promoters or third parties by covering all associated legal costs upfront, such as counsel fees, court fees, and other dispute-related expenses, in exchange for a share of the recovery, if successful. TPF covers litigation expenses, expert fees, and investigation costs by providing the necessary capital to pursue claims like fraudulent transactions that require specialised expertise and extensive financial resources. It can also improve asset realization for creditors by allowing RPs and liquidators to pursue and recover “contingent assets”, such as those tied to avoidance transactions, which would otherwise be left unpursued due to lack of funds. TPF ensures speedy recovery without depending on Coc approvals for every expense by giving the RP or liquidator access to immediate, non-recourse capital for specific legal actions, bypassing the often lengthy and cumbersome approval process.
Mechanism of Implementing TPF in Avoidance Actions
- The process begins with a RP or liquidator identifying a viable Avoidance Recoveries under IBC claim that could recover significant assets but is hindered by resource constraint.
- The RP then seeks funding from a third party funder, who agrees to cover litigation costs in exchange for a success-based return on investment, typically a percentage of recovered proceeds.
- A formal request for TPF is submitted, often requiring approval from the CoC under section 28 of the IBC, ensuring transparency and stakeholder alignment.
- The funder conducts due diligence on the claims merits, potential recovery value, and legal risks before committing capital.
- Upon agreement, the funder provides the necessary funds to cover legal fees, expert costs, and other litigation expenses, allowing the RP to proceed without depleting the estate’s limited resources.
- The professional then negotiates with funders regarding return percentage, and confidentiality.
- The RP or liquidator will then file applications before the National Company Law Tribunal (NCLT) with disclosed funding arrangement, if required.
Case Laws Supporting TPF in IBC Context
In SREI Infrastructure Finance Ltd. v. Sterling SEZ & Infrastructure Ltd., SREI Infrastructure Finance Ltd. filed an insolvency plea against Sterling SEZ & Infrastructure Ltd. in July 2018 over a default of Rs. 337 crore, which was later withdrawn with approval from over 92% of creditors in April 2019. The NCLT, Mumbai Bench allowed the withdrawal of the insolvency plea, but there is no information indicating the tribunal allowing third-party funding for Avoidance Recoveries under IBC transactions in this case. In the case of Nitin Jain, Liquidator of PSL Ltd. v. Directorate of Enforcement the court clarified that recoveries from transactions avoided under sections 43, 45, 49, and 66 of the IBC, such as preferential or fraudulent transactions, are not part of the liquidation sale but form part of the liquidation estate and can be pursued separately by the liquidator. These recoveries must be deposited in the liquidation account and distribution to creditors as per section 53 of the IBC, even if the liquidation process has been closed.
Read more : Time Limit on Admissibility of Claims During CIRP: Where to Draw the Line?
Benefits of Third-Party Funding in Avoidance Actions
TPF mitigates financial constraints and reduces risk by covering legal costs for avoidance actions on a non-recourse basis, and has the following benefits:
- Enhanced Recovery: It allows insolvency companies to pursue high-value claims that they otherwise would have abandoned due to cost constraints.
- Risk Sharing: As it shifts the financial risk of Avoidance Recoveries under IBC transactions to the funder, who covers legal costs in return for a share of any recovery, it allows pirates with limited resources to pursue valid claims without initial expenses.
- Increased Creditor Confidence: IPs can pursue complex and costly Avoidance Recoveries under IBC actions without straining the estate’s resources. By mitigating the financial risk of litigation, this results in more aggressive recovery that ultimately improves the overall realisation rate for creditors.
- Judicial Efficiency: TPF enhances judiciary efficiency by ensuring Avoidance Recoveries under IBC actions are managed by experienced legal teams, which streamlines the process because it simplifies complexities and supports quicker case resolution.
- Encourages Accountability: TPF incentivises investors to pursue recovery of fraudulently transferred assets, which in turn deters promoters from engaging in such illicit transactions. This mechanism holds wrongdoers accountable by providing the necessary resources to pursue litigation, ultimately enhancing stakeholder protection.
Challenges and Concerns in Adopting TPF under IBC
- Despite progress, the absence of a dedicated regulatory framework creates ambiguity around disclosures, funder control, and ethical obligations, highlighting the need for a hybrid model that combines IBC amendments with guidance from jurisdictions, like Singapore.
- It faces challenges related to confidentiality and conflict of interest, necessitating full disclosure to the CoC and the NCLT to ensure transparency, maintain the independence of the RP, and prevent potential conflicts arising from funder influence or undisclosed relationships.
- The equitable distribution of recovered assets under the IBC faces challenges due to conflicting priorities between financial and operational creditors, the impact of judicial interpretations on the waterfall mechanism, and the potential for certain operational creditors to gain priority over financial creditors, complicating the determination of fair return sharing.
- The lack of a dedicated farmwork results in concerns over the funder’s credibility and potential relationships with parties necessitating due diligence to prevent conflicts of interest and ensure the integrity of the insolvency process.
Global Perspective on Third-Party Funding in Insolvency
The global landscape for TPF in insolvency is marked by progressive legal framework in jurisdictions like Singapore and Hong Kong, which permit TPF with mandatory disclosure and regulatory oversight. In contrast, the United Kingdom and Australia are moving toward formal recognition and regulation of TPF, emphasising transparency and governance to balance access to justice with procedural integrity. India, while lacking a dedicated statutory framework, is evolving through judicial pronouncements that affirm the permissibility of TPF under contract and equity principles, with recent rulings clarifying that funders are not liable for adverse costs if not parties to the arbitration agreement. This judicial evolution signals a move toward a structured regime, aligning with international norms on disclosure tribunal oversight, though a formal legislative framework remains pending.
Future of Third-Party Funding in Indian Insolvency Ecosystem
Inclusion of TPF in the IBC and its regulations could provide clear guidelines for funder participation by establishing a hybrid regulatory framework that mandates CoC approval and full disclosure of funding terms, while capping success fees to align with models in Hong Kong and Singapore. This structured approach could protect creditors and debtors by ensuring funders, who lack a stake in the corporate debtor’s overall viability are excluded from the CoC, thereby preserving the IBC’s commercial intent of empowered financial creditors. By enabling a robust secondary market for insolvency claims, encouraging competitive bidding and enhancing price discovery for distressed assets. Given the growing acceptance of TPF in Indian law and its proven success in cases like Yashomati Hospitals, the Insolvency and Bankruptcy Board of India (IBBI) may eventually consider codifying TPF to enhance recovery efficiency and close the gap between admitted claims and actual realisations.
Conclusion
TPF can transform Avoidance Recoveries under IBC by enabling RPs to pursue high-cost legal actions during insolvency proceedings without diverting essential resources from the CIRP. This financial support allows creditors to recover value from disputed claims and avoidance transactions that might otherwise be abandoned due to financial constraints. Although India lacks a formal regulatory framework for third-party funding, judicial pronouncements have generally upheld the permissibility of such arrangements, signaling a positive shift toward greater creditor empowerment. Hence, Third-Party Funding stands as a pragmatic solution bridging resource gaps and strengthening India’s insolvency resolution framework.
FAQs
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What is Third-Party Funding in insolvency?
TPF in insolvency is a non-recourse funding arrangement where an external funder provides capital to a corporate debtor or insolvency professional to pursue litigation claims, such as Avoidance Recoveries under IBC actions or recovery of contingent assets, in exchange for a share of the proceeds if the claim is successful.
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Is Third-Party Funding allowed under the IBC?
Yes, as per judicial precedents, TPF is permitted under the IBC, particularly for litigation during insolvency proceedings.
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What are avoidance transactions under the IBC?
Avoidance Recoveries under IBC transactions are financial deals made by a corporate debtor before insolvency that disadvantage creditors or unfairly benefit certain creditors or related parties, and can be nullified to maximise assets for distribution.
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How does TPF help insolvency professionals?
TPF helps insolvency professionals by providing non-recourse financing for interim operational and legal proceedings during the CIRP, enabling them to maintain asset value, pursue Avoidance Recoveries under IBC actions, and enhance recovery potential without the burden of upfront costs or repayment if unsuccessful.
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Are there any risks in using TPF?
Yes, risks in using TPF in insolvency cases include potential loss of claimant autonomy, increased likelihood of litigation due to reduced settlement incentives, the possibility of the funding agreement being challenged on public policy grounds if the funder is not contractually liable for adverse costs, which could affect the validity of the agreement.
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