Implications of PUFE Transactions on Independent Directors under IBC

Arvind Devanathan

29 Dec 2022

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The principal object of Insolvency and Bankruptcy Code is to keep the corporate as a going concern and in case of an insolvency the rescue mechanism for a corporate debtor is achieve through a corporate insolvency resolution process and if no resolution is reached the corporate debtor is liquidated.

Insolvency and Bankruptcy Code have recognized certain avoidance transactions which are collectively referred as PUFE Transactions in the scheme of IBC.

• Preferential Transactions
• Undervalued Transactions
• Fraudulent Transactions
• Extortionate Transactions

 While every independent director is expected to be aware of the concept of above four transactions, in this article we will focus on fraudulent transactions which has got far greater impact on all directors including independent directors in the event the company at any point in time undergoes Corporate Insolvency Resolution Process under IBC or liquidation.

If during a Corporate Insolvency Resolution Process or a liquidation process, it is found that any business of the Corporate has been carried on with an intent to defraud creditors of the corporate or any fraudulent purpose the National Company Law Tribunal (NCLT) on an application made by a resolution professional pass an order that people who are knowingly party to business being conducted in such a manner shall be liable to make such contributions to the assets of the corporate as it may deem fit.

For the first time in the context of insolvency of a company fraudulent or wrongful trading provisions are inserted to make directors or partners of a corporate debtor personally liable to make contributions to the assets of the corporate debtor.

The liability would arise, if before the insolvency commencement date, the director or partner knew or to have known that there is no reasonable prospect of avoiding commencement of Corporate Insolvency Resolution Process and in spite of that such director or partner did not exercise due diligence in minimising potential loss to the creditors.

As per the IBC Code a director or partner shall deemed to have exercised due diligence if such diligence was reasonably expected of a person carrying out the same function that are carried out by such director or partner.

The code does not distinguish between independent director and executive director for the purpose of liability.

An independent director who is not involved in day-to-day operations will find it very difficult to unearth such frauds committed on the creditors of the company. However, it will not be too much to expect from him to find out or entertain doubts regarding certain transactions which are patently fraudulent transactions.

The independent director even without a financial background can examine related party transactions, undervalued transactions in favour of friends and relatives of the promoters or directors or diversion of funds for any purpose other than the purpose for which funds were borrowed or invested.

For example, a Mid-Size Pharma Company CEO draws a compensation of Rupees Three Crores, it is expected from the independent director to know at least the average salary drawn by CEOs of similarly placed pharma companies. Assuming that the compensation in the market is Rupees One Crore then the three-crore compensation drawn by a company in which Independent Director is in the board should see this as a red flag and seek clarification as to why the CEO is paid three times the market compensation.

If he does not do that it would be treated that he has not exercised his diligence properly. In such a case he is also indirectly responsible for the financial stress of the company leading to insolvency and therefore he can be made accountable and liable too.

Any transactions done with an intention to defraud creditors either in the form of preference to any party or undervaluation of assets transferred etc. would also invite actions including recovery of loss from directors/partners.

Though as per Companies Act, Independent Directors are liable only for the acts or omission or commission by the company that occurred with their knowledge, attributable through board processes and with their consent or connivance the companies act also provides that if the directors have not acted diligently then they are liable to all the stakeholders.

Once the corporate undergoes Corporate Insolvency Resolution Process due to financial stress, the PUFE transactions will eventually come out as resolution professional will invariably order for transaction audit or forensic audit as provided in the IBC code and the rules/regulations made thereunder.

Therefore, it can be reasonably concluded that independent directors of financially stressed companies will have to watch out diligently for PUFE transactions every time before he could go for the board meeting or at least during the board meeting and take appropriate action as may be required from an independent director.