Guarantors: The Unspoken Exception to the Clean Slate Theory

Introduction

Since the inception of the Insolvency and Bankruptcy Code, 2016[1] (IBC/the Code), the corporate insolvency resolution process (CIRP) has been shaped by the amendments to the Code and its regulations, and judicial developments alike. One of the core principles that govern the CIRP and implementation of the resolution plan is the clean slate theory. The clean slate theory found its footing in Essar Steel (India) Ltd. v. Satish Kumar Gupta[2] pronounced by the Supreme Court in 2019. This was informed by provisions of the Code and was delivered in response to the issue of validity of undecided claims, particularly those of personal guarantors. Since the conceptualisation of the clean slate theory, the same has been widely relied on as a non-negotiable factor to be fulfilled on approval of the resolution plan. However, not much has been said on the interplay of the clean slate theory and the initiation of CIRP against guarantors for the same debt and default as the principal borrower against whom CIRP has already been initiated. In this context, it is apposite to evaluate the ambit of the clean slate theory and its limitations.

What is the “clean slate theory”

The clean slate theory is founded on the basis of Section 31 of IBC[3] which provides that the resolution plan, once approved by the adjudicating authority is binding on the corporate debtor and its employees, members, creditors, including the Central Government, any State Government or any local authority to whom a debt in respect of the payment of dues arising under the law such as authorities to whom statutory dues are owed, guarantors and other stakeholders involved in the resolution plan.

The rationale for this legislative provision is to ensure that all valid claims are addressed in the approved resolution plan itself thereby leaving little to no room for such claims to be brought forth after the resolution plan has been approved. This ensures that on implementation of the resolution plan, the resolution applicant is not bombarded by a sudden influx of past claims of the entity prior to CIRP. By maintaining a clear framework that prevents perpetuity of claims against the corporate debtor, resolution applicants are encouraged to step forward and takeover the stressed entity.

In this regard, the High Court of Rajasthan on 7-4-2020 in Ultra-Tech Nathdwara Cement Ltd. v. Union of India[4] struck down and quashed the demands of Central Goods and Service Tax Department pending as on date of finalisation of the resolution plan. It was reaffirmed that once the resolution plan submitted by the resolution applicant has been accepted and approved by the adjudicating authority, the resolution plan is binding on all parties concerned including the statutory authorities. It was further explained that as per the newly amended (at the time) Section 31, the Central Government, State Government or any other local authority to whom, a debt in respect of payment of dues arising under any law for the time being in force are owed, have been brought under the umbrella of the resolution plan approved by the adjudicating authority which has been made binding on such governments and local authorities.

Therefore, it is explicitly clear that the government agencies and statutory authorities are bound by the resolution plan once approved and ought to raise any valid claims during the period of CIRP when the resolution professional calls for submission of claims against the corporate debtor. Thus, it is not open for creditors including the Government to disregard the established process as envisaged by the Code.

The clean slate theory in its essence is that the resolution applicant cannot suddenly be faced with undecided claims after the approval of the resolution plan as the resolution applicant is to run the business of the corporate debtor on a fresh slate. The Supreme Court in Essar Steel[5] fleshed out the theory by stating,

  1. A successful resolution applicant cannot suddenly be faced with ‘undecided’ claims after the resolution plan submitted by him has been accepted as this would amount to a hydra head popping up which would throw into uncertainty amounts payable by a prospective resolution applicant who successfully take over the business of the corporate debtor. All claims must be submitted to and decided by the resolution professional so that a prospective resolution applicant knows exactly what has to be paid in order that it may then take over and run the business of the corporate debtor. This the successful resolution applicant does on a fresh slate….

Similarly, in conformity with the clean slate theory, Section 32-A[6] as inserted subsequent to the pronouncement of the Essar Steel[7] judgment, provides that the liability of a corporate debtor for an offence committed prior to the commencement of the CIRP ceases, and the corporate debtor cannot be prosecuted for such an offence from the date of approval of the resolution plan by the adjudicating authority, if the resolution plan results in the change in the management or control of the corporate debtor to someone who is not a related party or other specified persons. Furthermore, no action can be taken against the property of the corporate debtor in relation to an offence committed prior to the commencement of the CIRP of the corporate debtor, where such property is covered under the approved resolution plan which results in the change in control of the corporate debtor to a person, or sale of liquidation assets under the provisions of Chapter III of Part II of the Code to someone who is not a related party or other specified persons.

The validity of Section 32-A was challenged before the Supreme Court in the matter of Manish Kumar v. Union of India[8] as decided on 19-1-2021. The Supreme Court in the matter noted that while Section 32-A intends to give a clean break to the successful resolution applicant, it is hedged with ample safeguards to avoid any exploitation. Such immunity is contingent on the fulfilment of several conditions such as approval of resolution plan, change in control of the corporate debtor such that the new management cannot be the disguised avatar of the old management or be a related party of the corporate debtor. Additionally, the new management cannot be the subject-matter of an investigation which has resulted in material showing abetment or conspiracy for the commission of the offence and the report or complaint filed thereto. More importantly, every person who was associated with the corporate debtor in any manner and who was directly or indirectly involved in the commission of the offence in terms of the report submitted continues to be liable to be prosecuted and punished for the offence committed by the corporate debtor. It was also noted that the corporate debtor and its property in the context of the scheme of the Code constitute a distinct subject-matter thereby justifying the special treatment accorded to them. It was elaborated that the extinguishment of criminal liability of the corporate debtor is important for the new management to make a clean break with the past and start on a clean slate. Such a provision is part of economic measure and deals with offences committed prior to the commencement of the CIRP.

In this respect, the National Company Law Tribunal (NCLT), Mumbai Bench vide order dated 19-5-2021, in Kamla Industrial Park Ltd. v. Monitoring Committee of Corporate Debtor [9], held that the new management of the corporate debtor could not be held liable and responsible for the malfeasance and misfeasance committed by the former promoters and directors of the corporate debtor and that it could not be saddled with the repercussions of reprehensible actions of the erstwhile management.

In the notable case of Ghanashyam Mishra and Sons Private Ltd. v. Edelweiss Asset Reconstruction Co. Ltd.[10], the Supreme Court on 13-4-2021 reiterated the clean slate theory and held that once a resolution plan is duly approved by the adjudicating authority, the claims as provided in the resolution plan stands frozen and is binding on the corporate debtor and its employees, members, creditors, including the Central Government, any State Government or any local authority, guarantors and other stakeholders. On the date of approval of resolution plan by the adjudicating authority, all such claims, which are not a part of resolution plan, stands extinguished and no person is entitled to initiate or continue any proceedings in respect to a claim, which is not part of the resolution plan.

Conflicts with the clean slate theory

I. Contingent waiver of liabilities owed to statutory authorities

Diverging from the established clean slate theory as seen above, several orders approving the resolution plan as seen in Vikram Sanghvi v. Bank of Baroda[11] and Edelweiss Asset Reconstruction Company Limited v. Lanco Hoskote Highway Limited[12] (delivered by the NCLT Ahmedabad Bench and Hyderabad Bench respectively) carry the caveat that waivers of obligations or any such reliefs are subject to the permission of the authority concerned.

The NCLT, Ahmedabad Bench in Vikram Sanghvi[13] on 26-4-2021 held that resolution applicant is required to approach the competent government authorities for any extinguishment, waiver or concession of claims as approval of the resolution plan does not imply an automatic waiver or abetment of legal proceedings pending against the corporate debtor as such legal proceedings are the subject-matter of the competent authorities concerned that have their own jurisdiction to pass appropriate orders.

When raised with the issue that such caveats leave the door open for additional undecided claims outside those addressed in the resolution plan, the  National Company Law Appellate Tribunal (NCLAT), at Chennai in Antanium Holdings Pte. Ltd. v. Sujana Universal Industries Ltd.[14] on 17-5-2021 upheld such stipulations by stating that same are merely observations that the adjudicating authority is permitted to express and are not in the form of “imposition of an additional condition” which opens up the plan to the undecided claims.

Granting the government authorities, the discretion to refuse waiver of the corporate debtor’s liabilities outside those addressed in the resolution plan is a significant indicator that the clean slate theory is not absolute.

II. Insolvency proceedings against guarantors

Insolvency proceedings of corporate guarantors

The NCLAT in SBI v. Athena Energy[15], on 24-11-2020 notably held that in the matter of guarantee, CIRP can be initiated against both the principal borrower and the guarantor. It was further elaborated that simultaneous remedy is central to a contract of guarantee and where the principal borrower and the surety are undergoing CIRP, the creditor can file claims in the CIRP of both parties. To avoid any unjust enrichment of the creditor, it was clarified that it would be a matter of adjustment when the creditor receives debt due from the principal borrower/guarantor in the respective CIRP that the same should be adjusted in the other CIRP.

Carrying this forward, the NCLAT in SBI v. Animesh Mukhopadhyay[16] on 8-3-2021 elaborated that till payment is received in one CIRP, claim can be maintained in both CIRPs for same amount and representation in Committee of creditors (CoC) in both CIRPs to the extent of amount due will be justified. Similarly, the NCLAT in Kanwar Raj Bhagat v. Gujarat Hydrocarbons and Power SEZ Ltd.[17] on 11-5-2021, held that an application under Section 7 is maintainable against the corporate debtor for the same debt and default even though the CIRP has already been initiated against the corporate guarantor and the financial creditor can recover the remaining dues from the corporate debtor.

Insolvency proceedings of personal guarantors

For the insolvency proceedings against personal guarantors, the validity of the Notification dated 15-11-2019 that brought into force provisions related to personal guarantors to corporate debtors under Part III of the Code in addition to the relevant Rules and Regulations thereunder was adjudicated by the Supreme Court in Lalit Kumar Jain v. Union of India[18] on 21-5-2021. The Supreme Court therein held that approval of a resolution plan does not ipso facto discharge the personal guarantor of a corporate debtor of their liabilities under the contract of guarantee. It was explicated that the discharge of the principal borrower from the debt owed by it to its creditor due to liquidation or insolvency resolution process does not absolve the guarantor of their liability which arises out of an independent contract. Such liability of the guarantor continues and the creditor can realise the same from the guarantor in view of Section 128 of the Contract Act, 1872[19] (Contract Act) as there is no discharge under Section 134 of the Contract Act[20]. While it was argued by the petitioner that by virtue of the holding of Essar Steel[21] and Section 31(1) of IBC, an approved resolution plan in respect of a corporate debtor amounts to extinction of all outstanding claims against that debtor; consequently, the liability of the guarantor, which is coextensive with that of the corporate debtor, would also be extinguished; it was definitively held that Section 31 of IBC does not operate to discharge the guarantor’s liability.

Subrogation rights of a guarantor

It is worth noting that guarantors are vested with the right of subrogation as under Section 140[22] and 141 of the Contract Act[23] which provides that the guarantor after paying the debt of the principal debtor against the creditor, is invested with all the rights of the creditor against the principal debtor. Essentially, the guarantor steps into the shoes of the creditor upon performance of their obligations. Owing to the clean slate theory, since no prior commitments or rights can be enforced once the resolution plan is approved and made binding on all parties including the guarantor, the natural implication is that subrogation rights can no longer be enforced after approval of the resolution plan to uphold the interest of the resolution applicant. As a result, guarantors will be left remediless which will greatly discourage guarantors from extending guarantees.

Conclusion

While there has been extensive reliance on the clean slate theory, it ought to be recognised that it is not absolute and that guarantors are the key exception to the clean slate theory. For the resolution applicant to effectively run the entity it is paramount that it receives the corporate debtor with a clean slate without the burden of pending liabilities and claims after CIRP and the implementation of the resolution plan.

In instances where the corporate entity undergoes CIRP due to external forces such as economic distress as opposed to internal factors such as fraud and mismanagement, the entity is granted reprieve as the resolution applicant takes control of the entity on a clean slate. However, it is recognised that insolvency and bankruptcy proceedings of an entity does not absolve the guarantor of their liabilities. This begs the question that if the distressed entity is granted the aid and relief of starting afresh on a clean slate in the hands of the successful resolution applicant, why are the rights of the guarantor ignored?

Due consideration ought to be made for the guarantors involved as creditors are given free rein to initiate insolvency resolution process against corporate and personal guarantors apart from corporate debtor i.e.  principal borrower. Moreover, in accordance with the clean slate theory, the guarantor’s right of subrogation extinguishes on the approval of the resolution plan. This marginalisation of guarantors serves as a significant hindrance to guarantors from extending guarantees. With this mounting stack of disadvantages with no remedy or benefit in sight, guarantors are left bereft and discouraged. Thus, one can hope that this crucial concern is adequately addressed and adjudicated upon to the benefit of all the stakeholders especially, guarantors.


* Principal Associate, Dhir & Dhir Associates.

** Associate, Dhir & Dhir Associates.

[1] http://www.scconline.com/DocumentLink/86F742km.

[2] (2020) 8 SCC 531

[3] http://www.scconline.com/DocumentLink/gvPKCciX.

[4]2020 SCC OnLine Raj 1097.

[5] (2020) 8 SCC 531, p. 616.

[6] http://www.scconline.com/DocumentLink/PEnh3D4C.

[7] (2020) 8 SCC 531.

[8] 2021 SCC OnLine SC 30.

[9] 2021 SCC OnLine NCLT 249.

[10] 2021 SCC OnLine SC 313

[11] 2021 SCC OnLine NCLT 298

[12] 2021 SCC OnLine NCLT 299

[13] 2021 SCC OnLine NCLT 298.

[14] 2021 SCC OnLine NCLAT 167.

[15] 2020 SCC OnLine NCLAT 774.

[16] 2021 SCC OnLine NCLAT 30.

[17] 2021 SCC OnLine NCLAT 157.

[18] 2021 SCC OnLine SC 396.

[19] http://www.scconline.com/DocumentLink/6D21Pq4g.

[20] http://www.scconline.com/DocumentLink/LHI883Dw.

[21] (2020) 8 SCC 531.

[22] http://www.scconline.com/DocumentLink/2vRS7GCk.

[23] http://www.scconline.com/DocumentLink/U4s5QmXr.

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