Personal Guarantee: The Enforcement Begins

On 21 May 2021, the Supreme Court of India, in the case of Lalit Kumar Jain vs. Union of India & Ors, upheld the provisions of the Insolvency and Bankruptcy Code, 2016 (“Code”) which permitted banks to proceed against personal guarantors for recovery of loans given to a company. Under the Code, the Government of India (“Government”) has been conferred powers to enforce certain provisions of the Code at different points in time. Accordingly, the Government has notified various provisions of the Code from time to time. The conflict at hand arose when the Government, vide a notification dated 15 November 2019 (“Notification”), brought into force provisions of Part III of the Code, only in so far as they relate to personal guarantors to corporate debtors. Though Part III of the Code provides for insolvency and bankruptcy for individuals and partnership firms, the Notification enforced the provisions only in relation with personal guarantors of corporate debtors.

Prior to the Notification, banks had to approach the Debt Recovery Tribunals under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 for recovering their money from their borrowers (including personal guarantors). Unfortunately, the Debt Recovery Tribunals were plagued by judicial delays which consequently undermined the efficiency of the process. As per the ‘Report on Trend and Progress of Banking in India 2019-20’ published by the Reserve Bank of India, as on March 2020 the recovery rate of Debt Recovery Tribunals stood at an abysmal 4%. Comparatively, during the same time, the recovery rate of National Company Law Tribunals under the Code was 45.5%. Therefore, the Notification was greeted with great gusto by creditors in hopes of better and expeditious recovery of their dues from personal guarantors of companies. On the other hand, a number of promoters of large companies, who had furnished personal guaranties for their companies, filed petitions in different High Courts challenging the Notification. The Supreme Court transferred all these petitions filed in different High Courts to itself so that the interpretation of the provisions of the Code relating to personal guarantors can be settled by the Apex Court once and for all which will also avoid any confusion due to contrasting views of the High Courts.

The contentions of the personal guarantors

The personal guarantors argued that the Government is only empowered to bring the provisions of the Code into force by a notification in the official gazette, at such time as it may decide. They further argued that the Government has exceeded the power conferred upon it under the Code to modify the provisions of Part III of the Code and make them applicable only to personal guarantors of corporate debtors.

Another objection raised was that the Notification failed to notify Section 243 of the Code, which repeals Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920.  Before issuance of the Notification, insolvency proceedings against individuals were governed by the aforesaid statues. The Presidency Towns Insolvency Act, 1909 is applicable to the erstwhile presidency towns such as Calcutta, Bombay and Madras, while the Provincial Insolvency Act, 1920 is applicable to the whole of India, except these towns. It was contended that by not repealing the said statues, the Notification is irrational as it creates two contradictory legal regimes for insolvency proceedings against personal guarantors to corporate debtors.

It was the stand of the personal guarantors that once a resolution plan for a corporate debtor is approved, any past, present, or future liabilities encumbered upon the corporate debtor stands extinguished. It was urged that in accordance with Section 128 of the Indian Contract Act, 1872, liability of a guarantor is co-extensive with that of the principal debtor, accordingly the conclusion of insolvency proceedings against a principal debtor i.e., the corporate debtor, on approval of resolution plan, would also amount to extinction of all claims against the personal guarantor.

Findings of the Supreme Court

The Supreme Court looked at the purpose of the Notification and observed that the Parliamentary intent was to treat personal guarantors differently from other categories of individuals. Supreme Court observed that the scheme of the Code always contemplated that assets of a corporate debtor and its personal guarantor could be dealt with in an identical manner during insolvency proceedings. It was for this reason that various amendments were made to the Code in a timely manner, such as

a.  Section 2(e) – making the Code applicable to personal guarantors to corporate debtors,

b.  Section 5(22) – definition of personal guarantor,

c.   Section 29A – guarantor of a corporate debtor against which insolvency proceedings has been initiated was made ineligible to submit resolution plans.

The Code had also contemplated that the adjudicating authority in respect of personal guarantors was to be the National Company Law Tribunal, and not the Debt Recovery Tribunal as is the case for individuals and partnership firms, therefore, making the intent of the legislature clear in terms of its treatment of personal guarantors. The Court held that the Notification was not an instance of legislative overreach by the Government, nor did it amount to selective application of provisions of the Code since there was no compulsion in the Code that it should be made applicable at the same time to all individuals, (including personal guarantors) or not at all.

The Supreme Court also opined that there was no over-lapping between the Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920, with the provisions of the Code. Placing reliance on Section 238 of the Code, which contains a non-obstante clause, the Court stated that the Code has an overriding effect over other prevailing and contradictory legislation.

The Supreme Court clarified that the sanction of a resolution plan does not by itself operate as a discharge of the personal guarantor’s liability, since the liability of the guarantor arises out of an independent contract. With regards to the nature and extent of the liability of the personal guarantor, the same would depend on the terms of the guarantee itself. Therefore, the release or discharge of a principal borrower from the debt owed by it to its creditor, by an involuntary process i.e., by operation of law, or due to liquidation or insolvency proceeding, will not absolve the guarantor of his or her liability. The Supreme Court also placed reliance on its previous judgments regarding the nature and scope of liability of personal guarantors and recognized that a guarantor cannot seek a discharge of its liability on account of approval of a resolution plan of the corporate debtor. Therefore, the Notification was held legal and valid.

Our thoughts

The Supreme Court’s judgment is a significant win for the lenders as it will allow them to recover any deficit amounts not covered by the resolution plan of the corporate debtors, from the personal guarantors of such corporate debtors. This can be done by initiating independent insolvency proceedings against such personal guarantors of the corporate debtors. In the past, directors / promoters of companies would agree to act as personal guarantors for loans availed by their companies and would later wriggle out of their liabilities largely due to an inefficient debt recovery system. This was also partly due to poor diligence on part of banks and the mechanical manner in which massive loans were issued to companies, which would largely outstrip the financial net worth of the guarantor by significant multiples. However, going forward, such practices are likely to change as directors / promoters would be wary of providing personal guarantees at the behest of companies that may expose them to risks of insolvency.

By upholding the Notification, the Supreme Court has also dealt a heavy blow to erring directors / persons controlling the corporate debtor at the relevant time, who may have transferred assets of the corporate debtor for their personal benefit or created structures to ring-fence their personal assets / wealth from creditors post issuing personal guarantee to the lenders. If any transaction were conducted by any persons linked to the corporate debtor to defraud the creditors, the insolvency courts in India may declare such a transaction void. In such an event, the transferred assets may continue to be treated as part of the bankruptcy estate of the personal guarantor. Therefore, with more to lose, directors / persons in control of the corporate debtor will certainly start to consider the requirement of giving personal guarantees and start negotiating the personal guarantees to ensure that all risks of the lenders are not covered by such personal guarantees. As the law on enforcement of personal guarantee given for a corporate debtor is attaining clarity, the terms and conditions of issuance of personal guarantees will certainly undergo a much-required change!

The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident, or any other cause.

Also Read: Note on Free Trade Agreement