What is a Preferential Transaction?

A **preferential transaction** occurs when a debtor, facing financial distress, transfers property, makes a payment, or creates a security interest in favour of a particular creditor, surety, or guarantor, thereby placing that party in a **better position than it would have been** if the transaction had not occurred and the debtor's assets were distributed in the normal course of insolvency proceedings.

In simpler terms, when a company on the verge of insolvency pays one creditor ahead of others, or transfers assets to a favoured party while leaving other creditors unpaid, that transaction is preferential because it unfairly benefits one party at the expense of the general body of creditors.

The **Insolvency and Bankruptcy Code, 2016 (IBC)** empowers the National Company Law Tribunal (NCLT) to **reverse** such transactions and recover the assets for equal distribution among all creditors.

Legal Framework — Section 43 IBC

Definition

**Section 43(2)** of the IBC defines a preferential transaction. A corporate debtor is considered to have given a preference if:

- The transaction involves a **transfer of property, or an interest in property**, of the corporate debtor for the benefit of a creditor, surety, or guarantor; **and**

- The transfer has the effect of putting such creditor, surety, or guarantor in a **more beneficial position** than it would have been in if the property had been distributed under Section 53 (the waterfall mechanism for distribution of assets in liquidation)

Look-Back Period

**Section 43(4)** specifies the relevant time period during which the transaction must have occurred:

- **Two years** before the insolvency commencement date if the beneficiary is a **related party** of the corporate debtor

- **One year** before the insolvency commencement date if the beneficiary is an **unrelated party**

Any preferential transaction occurring within these windows can be challenged and reversed.

Application by Resolution Professional

Under **Section 43(1)**, the **resolution professional** (or the liquidator, as the case may be) may file an application before the Adjudicating Authority (NCLT) to declare a transaction as preferential and seek appropriate orders.

Orders Available — Section 44

If the NCLT determines that a transaction is preferential, it may order under **Section 44**:

- The beneficiary to **pay back the amount** received or the value of the property transferred

- The transfer of property to the corporate debtor

- **Release or discharge** of any security interest created as part of the preference

- Such other orders as it deems fit to **restore the position** to what it would have been if the transaction had not been entered into

What is Not a Preferential Transaction?

**Section 43(3)** excludes certain transactions from being treated as preferential:

- A transfer made in the **ordinary course of business** or financial affairs of the corporate debtor and the beneficiary

- A transfer creating a **security interest in property** acquired by the corporate debtor, provided the security interest was created at the same time as the acquisition and to the extent of new value provided

These exclusions are important because they protect genuine, arm's-length commercial transactions from being unwound simply because they fell within the look-back period.

Judicial Interpretation

Anuj Jain v. Axis Bank (2020)

The Supreme Court in **Anuj Jain, Interim Resolution Professional for Jaypee Infratech Ltd. v. Axis Bank Ltd. (2020) 8 SCC 401** provided significant clarity on preferential transactions:

- A mortgage or security interest created by the corporate debtor in favour of a creditor of a third party (not a creditor of the corporate debtor itself) can be treated as a preferential transaction

- The Court emphasised that the IBC's avoidance provisions are designed to ensure **equitable treatment of creditors** and prevent the dissipation of assets to the prejudice of the general body of creditors

Jaypee Infratech

In the same case, the Court held that the resolution professional has the duty to investigate and challenge preferential transactions. The objective is to maximise the value of the corporate debtor's assets available for distribution.

When Do Preferential Transactions Matter?

Corporate Insolvency Resolution Process (CIRP)

During the CIRP, the resolution professional examines the corporate debtor's transactions within the look-back period to identify any preferential payments or transfers. Reversing such transactions increases the pool of assets available for the resolution plan or for distribution in liquidation, thereby benefiting the entire body of creditors.

Liquidation

When a company goes into liquidation under Section 33 of the IBC, the liquidator has the same power to challenge preferential transactions. Assets recovered are distributed according to the **waterfall mechanism** under Section 53, which prescribes the priority of payments — insolvency costs first, then secured creditors, workmen's dues, employee dues, unsecured creditors, and finally equity holders.

Related Party Scrutiny

Transactions with **related parties** (as defined in Section 5(24) of the IBC) attract greater scrutiny because of the inherent risk of collusion. The longer look-back period of two years for related party transactions reflects this heightened concern. Related parties include directors, partners, relatives, and entities under common control.

Distinguishing from Undervalued Transactions

While preferential transactions involve paying one creditor more than others, **undervalued transactions** under **Section 45 IBC** involve transactions where the corporate debtor receives conspicuously less than the value of what it gives. Both are avoidance provisions, but they address different types of pre-insolvency mischief. A single transaction may sometimes be challenged as both preferential and undervalued.

Practical Significance

- **Creditor equality:** The preferential transaction provisions enforce the fundamental insolvency principle that **similarly-situated creditors should be treated equally**

- **Maximises value:** Reversing preferences ensures that the maximum value is available for distribution among all creditors

- **Deters pre-insolvency manipulation:** Companies and their management know that transactions favouring specific creditors can be reversed, discouraging asset-stripping

- **Resolution professional's duty:** The IBC places an affirmative duty on the resolution professional to investigate and challenge such transactions

Frequently Asked Questions

Does the resolution professional need to prove intent to prefer a creditor?

Under **Section 43 of the IBC**, the resolution professional does not need to prove that the corporate debtor had a **subjective intention** to prefer one creditor over others. The test is objective — whether the transaction had the **effect** of placing a creditor in a more beneficial position than it would have been in the normal course of insolvency distribution. However, if the transaction was in the **ordinary course of business**, it is excluded from being treated as preferential under Section 43(3), regardless of its effect.

Can payments made to employees or workmen be challenged as preferential?

Payments made to employees and workmen for wages and salaries in the ordinary course of business are generally protected under the **Section 43(3) exclusion** for transactions in the ordinary course of business. However, if an employer makes disproportionately large severance payments or transfers assets to select employees shortly before insolvency in a manner that is not in the ordinary course, such transactions may be challenged as preferential.

What is the difference between a preferential transaction under IBC and under the old Companies Act?

The erstwhile **Section 531 of the Companies Act, 1956** also dealt with fraudulent preference but required proof of the debtor's **dominant intention** to prefer one creditor over others — a subjective test that was difficult to satisfy. The IBC under **Section 43** adopts an **objective test** focusing on the **effect** of the transaction rather than the debtor's intent. Additionally, the IBC provides clearer look-back periods and specific exclusions, making the avoidance framework more effective and predictable than its predecessor.