Companies Act Section 331

Companies Act, Section 331: Liabilities and Rights of Persons Fraudulently Preferred

Section 331 of the Companies Act, 2013 deals with the legal consequences for individuals who benefit from a fraudulent preference when a company is undergoing winding up. It expands upon Section 328, which prohibits such preferential treatment, by prescribing the liabilities and rights that arise for the person who was fraudulently preferred particularly where they are interested in mortgaged or charged property securing the company’s debt.

This provision ensures that fraudulent preferences do not unjustly benefit certain parties at the expense of the broader pool of creditors and that legal remedies exist to restore equity and fair treatment in the insolvency or liquidation process.

1. Liability of Persons Fraudulently Preferred

This provision applies when a company is in the process of being wound up and has previously undertaken an act that is later invalidated under Section 328 as a fraudulent preference.
If such a fraudulent act involves a person who holds an interest in a property that was mortgaged or charged to secure the company’s debt, the law imposes consequences on that individual.
Specifically, without affecting other legal rights or liabilities, the person who was fraudulently preferred shall:
Be considered as if they had personally undertaken the liability as a surety for the company’s debt. Their liability will be limited to either:
The extent of the mortgage or charge on the property, or The value of their interest in the property, Whichever is less.
2. Determination of Value of Interest

The value of the interest of the person fraudulently preferred must be assessed as on the date of the fraudulent transaction.
The valuation assumes that the interest is free from all other encumbrances, except the mortgage or charge that secures the company’s debt.
3. Tribunal’s Powers to Decide Questions Relating to Fraudulent Preference

A person (such as the Company Liquidator or a creditor) may approach the National Company Law Tribunal (NCLT) to raise a dispute about a payment made that is suspected to be a fraudulent preference of a surety or guarantor. The Tribunal is empowered to:
Examine any issues that arise between the recipient of such a payment and the surety or guarantor who might be affected.
Grant relief as appropriate even if resolving the dispute is not strictly necessary for the winding-up process.
Allow the inclusion of the surety or guarantor as a third party in the proceedings, similar to third-party procedures in civil suits, to facilitate a fair and complete adjudication.
4. Extension to Non-Monetary Transactions

The provisions of sub-section (3) apply mutatis mutandis (with necessary changes) to non-monetary transactions for example, the transfer of goods, property, or rights.
Illustrative Example:

Suppose a company, facing imminent insolvency, transfers a charged property to a creditor in a way that gives that creditor a better position than others just weeks before applying for winding up. If this transaction is declared a fraudulent preference under Section 328:

Under Section 331, the creditor will be deemed personally liable as a surety for the company's debt to the extent of the value of the property interest or the charge.
The Tribunal may also resolve disputes between the creditor and another guarantor regarding the payment or transfer and order equitable relief.
If the transaction involved a transfer of goods, similar rules would apply as if it were a monetary transaction.
Objective and Importance:

Section 331 serves several critical functions:

It deters preferential treatment of select creditors by holding them personally accountable. It ensures that all creditors are treated fairly and equitably in the winding-up process.
It gives the Tribunal powers to reverse the impact of fraudulent transactions and to ensure the integrity of the liquidation proceedings. It supports the broader objective of the insolvency framework to maximize asset value and protect the interests of all stakeholders.