Forensic Audit under the Insolvency and Bankruptcy Code 2016

The Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as “The Code”) was framed with the agenda of reviving a corporate debtor. The Code lays down a process which conducts the insolvency and liquidation proceedings in a time-bound fashion. The idea was to increase the efficiency of the insolvency process and to maximize the value of their assets. The Code has established several features and procedures. One of those address the nature and consequence of specific transactions. Sections 43 till 56 and then Section 66 deal with provisions which allow the Resolution Professional to avoid such specific transactions. The transactions to defraud the creditor made by the corporate debtor are called specific transactions. Such transactions include wrongful or fraudulent, undervalued, preferential transactions among others. The following article will deal with the provisions in the Code pertaining to the abovementioned specific transaction types.

Preferential Transactions – Section 43

This transaction takes place by the corporate debtor under two circumstances;

If the corporate debtor transfers property or its interest that arises from the benefit of a creditor. The benefit could be at the cost of guarantor or surety also. Where such transfer is taking place when an operational or financial liability already lies with the corporate debtor; and
This transfer mentioned under sub-clause (a) puts the creditor in a position of benefit as opposed to his position under the waterfall mechanism. This is specific to the distribution decided under section 53 of the Code.

A specific period comes under analysis when referring to such preferential transactions. This period is calculated preceding the insolvency commencement date; Related party – 2 years before the insolvency commencement date Other than related party - 1 year prior to the insolvency commencement date The Forensic Auditor has to conduct a review process in order to prevent such preferential transactions from transpiring. This process is called audit.

Process for review and audit

To identify preferential payments, the Forensic Auditor reviews the advances and loans repaid to the related party by the corporate debtor. He then compares these payments with the payments made to the secured lenders in the same period.
Assessment of transfer of assets made by the corporate debtor to lenders, secured or unsecured, and creditors in this period.
Any repayment of unsecured loans made in this period while drawing a comparison to payments done to secured lenders.
Analysis and review of journal register to check if any adjustments made in the entries.
Evaluation of non-consortium accounts to identify any separate receipts made to any specific creditor.
Analysis of age of creditors.

Undervalued Transactions – Section 45

This transaction that takes place by the corporate debtor under two circumstances as well;

Gift to another person; or
The corporate debtor enters into a transaction wherein the consideration that the debtor pays is valued higher in comparison to the value of the asset. Moreover, this transaction does not take place in the ordinary course of business.

A specific period comes under analysis for such undervalued transactions. This period is calculated preceding the insolvency commencement date; Related party – 2 years prior to the insolvency commencement date Other than related party - 1 year prior to the insolvency commencement date The Forensic Auditor has to conduct an audit to prevent such undervalued transactions from transpiring.

Process for review and audit

Assessment of the profit and loss ratio to do a review of the customer and product comparison. This helps in identifying the products and customers facing loss.
Comparison of transactions made to related parties with other entities to authenticate that the transactions have been made reasonably.
To benchmark undervalued transaction with the peer organizations to understand the reasonability of the transactions.
Assessment of ledger accounts.
Analysis of key ledgers like staff welfare, promotion gift etc.
Site visit and background verification for parties under suspicion.

Extortionate Credit Transactions – Section 50

Such transaction takes place by the corporate debtor under the following two circumstances u/s 50(2);

The transactions of the corporate debtor are exorbitant in comparison to the credit; or
Transactions made violate the law of contracts.

Period of Review - 2 years prior to the insolvency commencement date

Process for review and audit

The Forensic Auditor conducts an audit to identify and avoid such extortionate credit transactions;

He analyses the operational and/or financial debt incurred by the corporate debtor in the previous 2 years.
If such a debt exists, he then reviews the terms of such a debt to check whether it was exorbitant.
Review of the genuineness of the parties that lent the monies.

Fraudulent Trading or Wrongful Trading – Section 66

This section gives the power to the Resolution Professional to make an application to the adjudicating authority against the corporate debtor. Such an application will be based on the fact that corporate debtor conducts a business to defraud the creditors. The Adjudicating Authority can pass an order against all parties involved in such a wrongful business.

Process for review and audit

Forensic Auditor has to be more vigilant while making the review and analysis of such transactions.

Review of any facilities availed by the corporate debtor by overstating its sales, profit, assets, income etc. by providing a tampered financial statement.
Submitting false documents for stocks to draw from cash credits.
Evaluation of the funds that the bank sanctions, to check the purpose of its use.
Removal or disposal of assets of the corporate debtor without intimating the bank.
Using the short-term working capital without conforming with the terms of sanction.
Using the funds borrowed for purposes other than corporate and non-business accounts.
Writing off sale.

Present Status of Section 66

Insolvency and Bankruptcy Amendment Ordinance 2020 amended Section 66 of the Code. The amendment added another sub-clause to the provision i.e. Section 66(3). The amendment essentially suspends the Code for 6 months. Section 66(3) states that during this period of suspension, the resolution professional cannot make an application before the adjudicating authority. This application is in reference to the wrongful and fraudulent transactions.