Enforcement of Personal Guarantees: It’s a green for the Creditors!

July 2021

1. Introduction

The Ministry of Corporate Affairs issued a notification[1] (“Notification”) that categorised personal guarantors of a corporate debtor as a separate entity class to whom only certain provisions of Part III of the Insolvency and Bankruptcy Code, 2016 (“IBC”) applied. Part III provides for insolvency and bankruptcy for individuals and partnership firms. This empowered the creditors to invoke personal guarantees given by promoters, managing directors etc. of a corporate debtor even during the corporate insolvency resolution process (“CIRP”) of the latter. It exposed several such guarantors to extensive liability and they consequently challenged the Notification before various high courts on the ground that it is unconstitutional as it applies selective IBC provisions to them. Further, they argued that such a move only in relation to personal guarantors is impermissible in law and is a violation of legislative power by the executive. Later, these petitions were transferred to the SC through a transfer petition[2] who upheld the validity of the Notification in Lalit Kumar Jain v. Union of India[3] (“Lalit Kumar”).

This E-Newsline analyses the foregoing judgment and issues pertaining to enforcement of guarantees of the personal guarantors of a corporate debtor.

2. Setting the Context

It is essential to understand the background in which guarantees operate under Indian law, and is discussed below.

2.1        Co-extensive liability: The concept of a guarantee is enshrined under section 126 of Indian Contract Act (“ICA”). Essentially, it is a tripartite contract between a guarantor, the principal debtor and the creditor where the guarantor guarantees to discharge the liability of the principal debtor to the creditor, in case of a default. The key element to note is that the objective is to have a second pocket to pay, if the first is empty. An important feature of guarantees is the co-extensive liability of the guarantor with the principal debtor, which enables the creditor to seek recourse against the guarantor without exercising its legal remedies against the principal debtor.

2.2         Pre-Notification Situation: IBC enables creditors to initiate CIRP against a corporate debtor if it defaults on a debt. The principle of co-extensive liability permits creditors to initiate CIRP against the personal guarantor for the same debt. Previously, this avenue was not available to creditors and the jurisprudence was unsettled and conflicted. For instance, in Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta[4], the SC held that once a corporate debtor’s resolution plan is approved, it is binding on the creditors and other stakeholders, including guarantors. This implied that once the claims against the corporate debtor are extinguished, any liability owed by its guarantors must also be extinguished. But this was not necessarily so. In SBI v. V. Ramakrishnan and Ors.[5] SC reversed the decision of the National Company Law Appellate Tribunal, which denied the creditor from invoking a promoter’s personal guarantee due to a moratorium under section 14 of the IBC.[6] The SC held that creditors have the right to proceed against a personal guarantor and realise their debt even during a moratorium. While this was a pro-creditor verdict, the creditors were allowed to pursue their remedy before the Debt Recovery Tribunal (“DRT”) instead of the National Company Law Tribunal (“NCLT”).

3. Critical issues before the SC  

By virtue of the Notification, section 2(e) was modified to sub-categorise the entities into three parts: (i) personal guarantors (ii) partnership and proprietorship firms and (iii) other individuals. This allowed the central government to selectively apply IBC’s Part III to personal guarantors. In view of this the petitioner raised, amongst others, several important questions such as liability of personal guarantors, appropriate forum etc. The focus here is on the business aspects of insolvency of personal guarantors, enumerated below:  

3.1       Liability of personal guarantors: In Lalit Kumar, the petitioner contended that once the resolution plan for a corporate debtor is approved, it absolves the personal guarantors too from any obligation for that debt and binds all stakeholders under section 31(1)[7] of the IBC, including the guarantors. As a result, creditors are barred from initiating insolvency proceedings against personal guarantors.

The SC held that the finality of an approved resolution plan does not operate as a discharge of the personal guarantor’s liability. It took the position that the discharge of liability of a corporate debtor is separate from a personal guarantor. Once a resolution plan is approved, a corporate debtor is released. This is an involuntary process i.e. by operation of law. On the contrary, the discharge of a personal guarantor emerges from an independent contract of guarantee under section 126 of the ICA. Consequently, creditors have the freedom to initiate insolvency proceedings against the personal guarantors’ even after the approval of the resolution plan.

3.2      Moratorium: The insolvency of personal guarantors involves moratorium at 2 stages (a) “interim moratorium[8]”; effective from the time of filing the insolvency application till its admission, during which the resolution professional examines the application and submits a report to the adjudicatory authority recommending its approval or rejection; and (b) when the application is admitted by the adjudicatory authority.[9] Once the application is admitted, the interim moratorium ceases and moratorium at stage (b) immediately applies to the personal guarantor. During these two periods, no judicial or legal proceedings can be instituted or continued against guarantors towards recovery of any debt, enforcement of security interest, sale or transfer of assets, or termination of essential contracts. In Lalit Kumar, the petitioner contended that the personal guarantor’s debt is same as the corporate debtor, a moratorium issued against the former under (a) or (b) above would trigger a moratorium against the latter under section 14. This means the CIRP process would not be allowed to proceed. The petitioner urged that this amounts to treating unequals as equals, as a corporate debtor and personal guarantor are put on the same pedestal, which is not IBC’s objective. 

The SC disagreed and held that the moratorium for corporate and personal debtors is distinct. The two moratoriums at (a) and (b) above apply only to the debts for which a guarantor has given a guarantee, whereas a general moratorium under section 14 applies against the corporate debtor wherein all legal and judicial proceedings are stayed against it. Further, the SC relied on sub-section 14 3(b)[10] to show that moratorium envisaged under section 14 does not extend to personal guarantors.

3.3      The Forum Debate: The petitioner argued that the Notification amounts to wrongful application of IBC as it makes NCLT the adjudicating authority for insolvency of personal guarantors. They submitted that personal guarantors are “individuals” which can be clearly seen from a combined reading of the unchanged section 2(e)[11] and section 5(22).[12] Accordingly, personal guarantors should be dealt before the same forum as partners of firms and other individuals i.e., before the DRT.

The SC held that partners of firms and other individuals are a different class who do not share a close connection with corporate debtors as personal guarantors do. In fact, the latter often lead the corporate debtor’s affairs and can be the predominant reason for their insolvency. So, it would be wrong to identify personal guarantors as “individuals.” Furthermore, the SC stated section 60 ensures IBC always intended to deal with personal guarantors through the same adjudicatory forum as the corporate debtors. Specifically, section 60(1) stipulates NCLT to be the adjudicatory authority for personal guarantors and section 60(4) vests NCLT with all powers of DRT under IBC Part III. Additionally, the SC noted that if an integrated position is not taken, the CIRP process would exclude personal guarantors and impact the successful applicant in the CIRP who would be exposed to huge liability. It would then have to separately initiate insolvency against the personal guarantors in DRT thereby thwarting the objective of IBC as a recovery mechanism.

Due to the intrinsic relationship, there are cogent reasons for having a common adjudicatory authority. The NCLT will be well-positioned to consider the complete picture on the nature of assets available, either during the CIRP process or later. It would also enable the committee of creditors to frame realistic resolution plans, keeping in mind the prospect of realising some part of the creditor’s dues from personal guarantors. Further, adjudication by the same forum eliminates the risk of divergent rulings in matters arising out of the same transaction.

3.4      Non-enforcement of section 243: The petitioner also contended that the Notification fails to implement IBC’s section 243 whose sub-section (1) repeals the legislations (Presidency Towns Insolvency Act 1909 and Provincial Insolvency Act, 1920), that govern the insolvency of personal guarantors. He argued that the Notification leads to duplicity of proceedings as creditors can now initiate insolvency proceedings against personal guarantors under IBC and the abovementioned statutes.

The SC held otherwise and stated that section 243 must be read in its entirety to understand its non- operation as sub-section (2) preserves the pending proceedings under the two legislations, after their repeal. The objective of the Notification was to bring all personal guarantors under IBC and if section 243 was notified, then some personal guarantors would be left before the two legislations. It relied upon section 238 that gives IBC an overriding effect over other prevailing and contradictory legislations and concluded the Notification ensures that all proceedings against personal guarantors are heard under IBC.

4. Some unanswered questions

The SC did not clarify whether both financial and operational creditors can pursue CIRP against personal guarantors. Since guarantee under IBC is defined as an extension of financial debts, it may be assumed that only financial creditors can pursue CIRP against personal guarantors and the fate of operational creditors will be left to a potential future litigation. Furthermore, Lalit Kumar is silent on whether the right of subrogation is available to the personal guarantors upon completion of their CIRP. Subrogation implies that once a guarantor settles creditor’s claims, it steps into the shoes of the latter and can recover from the principal debtor monies paid on its behalf. It is necessary to balance the interests of the corporate debtor and rights of a personal guarantor. Often, key officers and directors are personal guarantors and their right to recover should not have been taken away as this right is a cardinal principle of guarantee. Instead, it seems that the SC has retained the liability of a personal guarantor; however, its corresponding right is restricted.

5. Conclusion  

Lalit Kumar leaves personal guarantors in a precarious position. It ensures greater accountability on their part who will certainly think twice before furnishing guarantees in their personal capacity. They will certainly negotiate hard on the guarantees terms to minimize their risks considering the consequences in case of default by their companies. Additionally, NCLT will have more debt recovery cases to deal with as creditors can recover their dues from both the corporate debtor and personal guarantors before one forum, simultaneously. The verdict furthers the spirit of the IBC since all the red signals for the insolvency resolution of personal guarantors seem to have turned green.

Author

Rishi Sehgal

[1] https://www.ibbi.gov.in/uploads/legalframwork/1fb8c2b785f35a5126c58a2e567be921.pdf (accessed on July 4, 2021)

[2] See: https://ibbi.gov.in/uploads/order/0cc711d10c8ecd89c286f79c4e074e8f.pdf (accessed on July 4, 2021)

[3] 2021 SCC OnLine SC 396

[4] 2019 SCC OnLine SC 1478

[5] AIR 2018 SC 3876

[6] Moratorium occurs on the following things during the pendency of CIRP: (i) institution or continuation of judicial proceedings against the corporate debtor; (ii) alienation of assets; (iii) enforcement of security interest; and (iv) recovery of any property in possession of the corporate debtor

[7] Section 31(1) states that once the resolution plan is approved by the adjudicating authority it shall be binding on all stakeholders including the guarantors

[8] Section 96 stipulates for an “interim moratorium” in relation to any debts of the guarantor as soon as the insolvency application is filed before the adjudicating authority

[9] In the event the application for insolvency is admitted by the adjudicatory authority, a moratorium in relation to the guarantor automatically comes into effect under Section 101

[10] Section 14(3)(b) prohibits the application of moratorium to a surety in a contract of guarantee to a corporate debtor

[11] Section 2(e) grouped partners of firms and other individuals together as one the of the entities to which the IBC applies 

[12] Section 5(22) defines personal guarantor as an individual who is the surety in a contract of guarantee to a corporate debtor