The Supreme Court’s recent judgment on the liability of personal guarantors when a company undergoes insolvency is a cautionary call to guarantors treading dangerous waters that will surely stir up a storm.
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A discussion on the effect of personal guarantees on a business debtor facing bankruptcy under the Insolvency and Bankruptcy Code, 2016 brings up several legal questions.
A personal guarantee is a promise made by an individual (the guarantor) to pay back a debt if the corporate debtor (the borrower) defaults on its obligations to a creditor.
The total claims accruing from matters where the admitted claim breaches the ₹1,000 crore mark add up to a massive ₹8.78 lakh crore, as per the quarterly report of the Insolvency and Bankruptcy Board of India (IBBI) published in September 2023.
Roughly 70 percent of the claims are backed by personal guarantees. This means that if a company cannot pay back its debts, the directors or promoters who provide personal guarantees may be on the hook to repay the loans.
The judgment
A personal guarantor is directly subject to bankruptcy proceedings, following the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 (2018 Amendment Act) and Notification No. S.O. 4126, dated November 15, 2019 (2019 notification), without the need for creditors to first initiate the insolvency proceedings against the corporate debtor.
The 2018 Amendment Act brought changes to Section 60 of the code, which established the powers of the National Company Law Tribunal to adjudicate matters of insolvency of a corporate debtor, including the personal guarantor.
The total claims accruing from matters where the admitted claim breaches the ₹1,000 crore mark add up to a massive ₹8.78 lakh crore, as per the quarterly report of the Insolvency and Bankruptcy Board of India published in September 2023.
The scope of the obligation imposed on the personal guarantors by the Act and the validity of the provisions in the code were recently elucidated by the Supreme Court.
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In Dilip B. Jiwrajka versus Union of India, decided on November 9, 2023, the Supreme Court rendered a judgment that resolved some ambiguities regarding the liability of personal guarantors under the code.
The ruling is significant because it gives the corporate debtor’s creditors more negotiating power to recover any unpaid sum not collected during the corporate insolvency resolution process or the personal guarantor’s insolvency resolution process.
Creditors can now recover their debts from many sources, thus creating a ‘dual safety net’. The Supreme Court’s decision in Dilip B. Jiwrajka has reinforced the strong negotiating position of the creditors, limiting the protection of personal guarantors under the code.
Challenging the 2019 notification
Following the release of the 2019 notification, many aggrieved personal guarantors approached the Supreme Court, which delivered a pivotal judgment.
In Lalit Kumar Jain versus Union of India, a division Bench determined the unresolved position by ruling that the release of the personal guarantor from its obligations is subject to two circumstances.
First, unless the contract expressly states otherwise; and second, if it is the consequence of a voluntary action by the corporate debtor, such as a discharge, modification or release of the guarantee agreement.
Paradigm for co-extensiveness
According to Section 128 of the Indian Contract Act, 1872, an obligation of the personal guarantors is coextensive with that of the corporate debtor. An independent contract establishes a personal guarantor’s liability.
Thus, creditors have the option to file a lawsuit concurrently against the corporate debtor and its personal guarantor, or they may proceed in any other order of their choice. The entire sum or the remainder may be recovered by legal action taken against the personal guarantor.
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In Maharashtra State Electricity Board Bombay versus Official Liquidator, Section 134 of the Contract Act was brought into play, which decided that the guarantor could be sued because the debtor was released from its liability as a result of an involuntary process of operation of law— insolvency— rather than as a result of any action or inaction on the part of the creditor.
In this case, the court examined that since there is no dismissal under Section 134 of the Contract Act, a guarantor’s duty under an unambiguous promise persists.
In Dilip B. Jiwrajka versus Union of India, decided on November 9, 2023, the Supreme Court rendered a judgment that resolved some ambiguities regarding the liability of personal guarantors under the code.
It is well-established that all obligations, liabilities and payments for earlier periods are eliminated upon approval of a resolution plan for a corporate debtor.
Nevertheless, this discharge is limited to the corporate debtor and does not relieve the company’s directors— who could have served as personal guarantors— of their duty to reimburse the creditors by the provisions of the agreement they have executed.
Reason for interpretation
In State Bank of India versus V. Ramakrishnan, it was held that acceptance of a resolution plan does not ipso facto result in the discharge of the guarantee. Instead, it may empower creditors to take action against the guarantor to collect any unpaid gap or deficit in the amount owing to them by the corporate debtor.
In the above judgment, Justice R. F. Nariman held that when a resolution plan authorised by the certificate of conformance takes effect, it is enforceable on both the corporate debtor and the guarantor.
If it were not understood in this manner, any alteration made to the corporate debtor’s obligation without the permission of the guarantee would exclude the guarantor from repayment.
Section 31(1) of the code crystallises the fact that a guarantor “cannot escape payment as the resolution plan, which has been approved, may well include provisions as to payment to be made by such guarantor”.
The Bench further observed that in most cases, personal guarantees are given by directors or promotors, who are actively involved in the day-to-day operations of the company.
Section 14 of the code does not intend for such guarantors to escape from the co-extensive liability to pay outstanding debt, which is why the moratorium does not apply to them and it is only limited to corporate debtors.
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However, guarantees given for individuals and firms in respect of their individual debts are given by guarantors who may be complete strangers to the debtor, usually also a personal friend.
Since the code is vague and silent, it is unclear whether creditors have the power to enforce assurances after a resolution plan has been authorised. In the absence of any clarity, the guarantor’s responsibility to creditors may be judged based on the circumstances of the case at hand.
Unfettered power for creditors
Following Lalit Kumar, several cases were filed challenging the constitutional validity of the code’s provisions regarding the liability of personal guarantors, claiming that the risk for personal guarantors to be targeted under insolvency matters is excessive and disproportionate.
In Lalit Kumar Jain versus Union of India, a division Bench determined the unresolved position by ruling that the release of the personal guarantor from its obligations is subject to two circumstances.
Personal guarantors are exposed to direct bankruptcy procedures and they are not given a fair chance to raise objections after the submission of insolvency petitions by creditors before the resolution professional, it was argued.
Dismissing the petitions, the Supreme Court concluded that a resolution professional’s job is solely that of a facilitator, not that of an adjudicator.
In Dilip B. Jiwrajka, the court held that the resolution expert is only selected by the adjudicatory authority on the recommendation of the Insolvency and Bankruptcy Board of India. The resolution professional’s primary purpose is to help in the facilitative procedures to prepare a report in line with Section 99 of the code.
The court decided that the present statutory framework does not permit an additional adjudicatory step, and that introducing one would require “rewriting the terms of the statute”.
It further said that there are severe deadlines for hiring a resolution specialist and submitting a report. Adding an adjudicatory step would not only hinder the process but also make it more difficult.
The court held that Sections 95 to 100 of the code cannot be declared unconstitutional only because there are no measures permitting personal guarantors to state their case before creditors file bankruptcy applications.
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The recent verdict is a significant breakthrough as it reassures that adequate safeguards are in place to ensure the successful performance of resolution specialists throughout the insolvency proceedings. However, the protection afforded to personal guarantors under the code remains minimal.
Issues for consideration
The code poses a contradiction by ensuring increased recovery for creditors while laying significant challenges on individuals acting as guarantors.
It is well-established that all obligations, liabilities and payments for earlier periods are eliminated upon approval of a resolution plan for a corporate debtor.
The possibility of multiple and concurrent insolvency proceedings is one significant issue. The co-extensive responsibility of debtors and guarantors permits creditors to file bankruptcy proceedings against both parties simultaneously.
Section 60(2) of the code requires filing insolvency petitions against guarantors if the corporate insolvency resolution process for the borrower is in progress, causing ambiguity in precedence and preparation of a repayment plan in different cases.
The issue of res-subjudice also needs to be addressed as the code allows concurrent processes when an action on the same case, same issue and same parties is ongoing before a tribunal.
There is an apparent disparity in the minimum threshold to initiate the corporate insolvency resolution process against corporate debtors and personal guarantors, where the amount of default is not less than ₹1 crore and ₹1,000 respectively.
It is manifestly a harassment to personal guarantors and the corporate insolvency resolution process for such a marginal amount may absurdly halt the corporate insolvency resolution process against the corporate debtor owing to the application of Section 101.
There is no clear legal position on whether creditors may sue the personal guarantor for the whole amount or the balance amount after a resolution plan is approved but before it is actually paid off.
As a result, if the creditor is allowed to continue for the whole amount, the creditor may unfairly recover more debt than what is owed. The personal guarantor is at a greater disadvantage as the law eliminates their right of subrogation and renders them toothless.
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The code’s extinguishment of a personal guarantor’s right of subrogation stands out as the Achilles heel that the courts have yet to consider. Traditionally, guarantors have the authority to act as the creditor and retrieve funds paid on behalf of the principal debtor.
While it is commendable that the code has a pro-creditor approach which will elevate creditor confidence, on the flip side, it may also lead to extreme caution among promoters or individuals offering guarantees for solvent companies.
However, the code restricts guarantors of this authority, emphasising the insolvency regime’s ‘pro-creditor’ perspective. Due to the code’s uncompromising stance towards personal guarantors, denying the right of subrogation will only prevent personal guarantors from providing guarantees.
Conclusion
Personal guarantors form the basis of the credit-lending regime. The provisions of the code are undeniably tipped in favour of creditors and they must be scrutinised by the Supreme Court as they seem to infringe on constitutional requirements and the concept of audi alteram partem for personal guarantors.
The code is a constructive legislation established to strengthen businesses in India and such sanctions against personal guarantors offer resolution professionals enormous authority with little checks and balances, which may discourage individuals from giving personal guarantees, thereby causing an imbroglio.
While it is commendable that the code has a pro-creditor approach which will elevate creditor confidence, on the flip side, it may also lead to extreme caution among promoters or individuals offering guarantees for solvent companies.
