The Conundrum Regarding Liability of Personal Guarantors to Corporate Debtors under IBC

Aritra Mitra*

A division bench of the Supreme Court consisting of Justices Ravindra Bhat and L. Nageswara Rao, via its judgment in Lalit Kumar Jain v Union of India &Ors. dated 21.05.2021, upheld the validity of a notification dated 15.11.2019. This notification was being issued by the Central government, which enabled provisions related to personal guarantors to corporate debtors from 1st December 2019. The Court also held that merely an approval of a resolution plan against a corporate debtor ipso facto did not remove all liabilities under the contract of guarantee or an independent contract, of a personal guarantor to a corporate debtor.

Brief Background

Through the aforementioned notification, the Central Government had notified that, certain provisions of Part III of the Insolvency and Bankruptcy Code, 2016 [IBC] will be applicable only to a personal guarantor and corporate debtor through the powers conferred under Section 1(3) of the IBC. This particular notification was challenged in several High Courts, challenging its vires and validity. Later the case was transferred to the Supreme Court. This notification enabled lenders to initiate insolvency proceedings against personal guarantors. It was followed by notification of 2019 Rules and Regulations.

After the notification was put out by the Central government, many petitioners were served with demand notices on several counts, with the proposal of initiation of insolvency proceedings under Part III of the IBC. These petitioners included people, who had assured personal guarantees to financial institutions for loans to companies in which they were a part. This caused these petitioners to challenge the government notification before the respective High Courts. Later the Supreme Court transferred all the cases under Article 139A to itself.

Findings of the Supreme Court

• Excessive Delegation and Selective Application

The Court observed that the notification has not fulfilled the criteria of legislative exercise and was not even a selective application. It considered the phased implementation of the IBC.  The Court stated that there was nothing explicitly mentioned that provisions of the Code needed to be applied to all individuals. Further, it also noted that personal guarantors to a corporate debtor have been given necessary recognition and statutory backing in the form of 2018 amendment in Section 60 and Section 2(e) and not just the notification. The Court observed that the Parliament had the necessary authority to issue the notification. There is no delegated legislation through the notification.

• Inconsistency in Provisions Enforced by the Notification and IBC

The petitioners have raised the contention that insolvency proceedings, application of moratorium and certain other provisions are inconsistent, but this contention was rejected by the court. The Court also stated that unifying the insolvency proceedings of debtor, personal guarantor, and a corporate guarantor will allow the adjudicating authority i.e., NCLT to view the whole picture and will provide momentum to the insolvency proceedings. It will also allow the committee of creditors to frame plans considering creditors’ dues from personal guarantors.

• Liability of Personal Guarantor

The successful conclusion of a resolution process for a corporate debtor is synonymous with a successful resolution plan extinguishing the whole or part of the debt. But the Court noted that the sanction of a resolution plan did not absolve a personal guarantor of his liability. The nature and extent of liability depended on the terms provided in the guarantee. Referring to Vijay Kumar Jain v Standard Chartered Bank, the Supreme Court allowed the participation of directors in the meetings of committee of creditors because the liability of a director persisted against the creditors. Even if the claims against a corporate debtor are removed, the same thing does not happen for personal guarantors, because all avenues are kept open for creditors to go against a personal guarantor. Section 133 of the Contract Act states that a surety would be discharged of the liability under a contract of guarantee if the terms of the contract are varied without the acquiescence of the said surety. However, the Court placed reliance upon SBI v. V. Ramakrishnan, where it observed that section 31 of IBC clearly binds the approved plan on the guarantor. Thus, the Court held that approval of a resolution plan would not ipso facto discharge a personal guarantor of their liabilities under the contract of guarantee.[1]

Analysis

The Supreme Court’s decision is a major win for lenders since it allows them to collect any shortfall amounts not covered by the corporate debtors’ resolution plan from their personal guarantors. This can be accomplished by filing independent insolvency procedures against the corporate debtors’ personal guarantors. In the past, company directors and promoters would slip out of their obligations, owing to an ineffective debt recovery mechanism. This was partially due to banks’ lack of due diligence and the mechanical method in which enormous loans were granted to firms, which far outstripped the guarantor’s financial net worth by substantial amounts. Such practices are expected to alter in the future, as directors and promoters will be apprehensive of offering personal guarantees at the request of firms that may expose them to risks of insolvency. This judgment also boosts lenders capability to recover the maximum amount of debt and also not allow promoters or personal guarantors to a corporate debtor to be absolved of their liability, just because the corporate debtor has gone insolvent.

It has been very favourable for banks and other financial institutions as it will be used as an effective tool for the recovery of bad debts. But with so much power allotted to banks and financial institutions, they will gain dominance amongst the borrowers and lenders. The question that arises is, how will these institutions deal with minor defaults made by small borrowers and what shall be the possibilities of the settlements between these borrowers and banks. The author feels that there are chances that this decision might restrict the expanding capabilities of small and micro corporate entities and also might affect their ability to take risks, since the lending banks can now recover maximum amount of debt.

The judgment also clarifies the issue of liabilities of personal guarantor to a corporate debtor and the route to follow in order to initiate recovery against the guarantor. Creditors can recover their dues from both the corporate debtor and the personal guarantor thereof under one forum simultaneously. Further, the judgment reiterates the position in Committee of Creditors of Essar Steel v. Satish Kumar Gupta, namely, upon completion of the CIRP of a corporate debtor, the creditors who would otherwise be taking a haircut, are entitled to separately proceed against the personal guarantor to the corporate debtor to recover the remainder of the amounts, assuming the resolution plan does not extinguish the guarantors’ liability. This decision will ensure strict credit behaviour and would make personal guarantors accountable and make them more diligent while extending guarantees.

The decision has failed to consider the constitutional values of delegated legislation. Section 1(3) of the IBC enables the union government to enforce certain sections during different intervals, but it prevents the government from categorizing any part of the provisions or apply the rules on certain group of people. This legislation empowers the government to enforce the law whenever it pleases. In such cases, the law has very limited room for future changes. The author feels that the government should be deciding when and how the law shall be applicable rather than pick which subjects to be covered by this law.

Then comes the primary borrower’s discharge through the sanction of the resolution plan. After the acceptance of the plan, the corporate debtor, members, guarantors, and other concerned parties are bound by it. Since it is a primary contract, the responsibility of the guarantor is co-extensive with that of the primary debtor.[2] If the latter’s obligation is discharged, then the surety’s duty also gets discharged. Also, according to the “clean slate theory” once a resolution plan is approved, a corporate debtor cannot be made liable for any offence committed prior to the commencement of CIRP or any surprise debts cannot be sprung upon the resolution applicant, which were not laid down in its resolution plan.

But the court in this instance, placed reliance upon SBI v V. Ramakrishnan, which mentioned that the IBC allowed personal guarantors to escape accountability once the resolution plan was authorized. This affects the rights of a third person, who in this case isn’t even a party to the contract by denying him the opportunity to apply for subrogation rights and relieving him of co-extensive obligation, which is in violation of Section 30(2)(e) of IBC.[3] The interests of the corporate debtor must be balanced against the rights of a personal guarantor. The directors are, in most circumstances, personal guarantors, and their right to collect from the corporate debtor should not be taken away lightly.

While the ruling has clarified that approval and finality of the resolution plan under Section 31 of the IBC[4] do not automatically discharge the guarantors’ liability, but can only result in a revision of the amount or exposure, more clarity is needed on the guarantors’ liability if the resolution plan leads to the assignment of the debt owed to the creditors to a resolution applicant or a third party, or conversion of debt owed to the creditors into equity or preference shares. A haircut taken by the creditors, i.e., the revised obligation of the guarantors, is equal to the entire debt less the amount obtained by the creditors under the resolution plan, according to the commercial agreement. In situations of debt assignment or debt conversion into preference or equity shares, the same has yet to be validated by the courts.

*The author is a second-year student at National Law University, Odisha

[1] Industrial Finance Corporation of India Ltd. v. CannanoreSpg. &Wvg. Mills Ltd., 2002 5 SCC 54.

[2]Bank of Bihar v. Damodar Prasad, AIR 1969 SC 297; Maharashtra State Electricity Board v. Official Liquidator, AIR 1982 SC 1497; State Bank of India v. Indexport Registered, (1992) 3 SCC 159; Ram Kishun v. State of UP, (2012) 11 SCC 511.

[3] Insolvency and Bankruptcy Code, 2016, § 30(2)(e), No. 31, Acts of Parliament, 2016 (India).

[4] Insolvency and Bankruptcy Code, 2016, § 31, No. 31, Acts of Parliament, 2016 (India).