Upholding the Validity of Provisions Related to Personal Guarantors Under IBC – Good for Lenders, Bad for Guarantors

Introduction

In a historic ruling¹, the Supreme Court declined to grant personal guarantors relief from a company’s default under the Insolvency and Bankruptcy Code, 2016² (IBC). The Court maintained the validity of several important IBC provisions, including the ability to file for bankruptcy against guarantors.

Over 200 petitions have been filed against various provisions of the IBC since it was amended in 2019³ to allow for recovery from guarantors. These include applications by creditors to start the insolvency resolution process against personal guarantors, interim moratoriums, and the appointment of resolution professionals.

To clarify, an individual who offers to guarantee the obligations of a borrower, usually a corporate entity, to a lender is known as a personal guarantor. The personal guarantor is responsible for repaying the debt on the borrower’s behalf in the event that the borrower defaults on its responsibilities. This article aims to shed light on the liability of personal guarantors under the IBC and the implications it carries for them.

First, the author explores the pre-amendment position of the Code on personal guarantors and then, the author underscores the need to introduce the amendment. Second, the author analyses the disputes post-amendment, particularly the present case, and analyses the Tribunal’s and subsequently, the Supreme Court’s reasoning. Lastly, the author examines the possible consequences of the judgment on lenders and guarantors in the future. Pre-amendment position on personal guarantors

The question that came before the Supreme Court in SBI v. V. Ramakrishnan⁴ was whether Section 14⁵ IBC, which establishes a temporary moratorium, would also apply to a personal guarantor of a corporate debtor.

The Supreme Court made it clear that personal guarantors are not covered by the moratorium; rather, it only applies to the corporate debtor.

Later, the questions whether the corporate insolvency resolution process (CIRP) can be started against a corporate guarantor in the event that the principal borrower is not a corporate debtor or corporate person, as well as whether it can be started against two corporate guarantors concurrently for the same set of debt and default, came up in Vishnu Kumar Agarwal v. Piramal Enterprises Ltd.⁶

In response to the first query, the National Company Law Appellate Tribunal (NCLAT) held that it is not necessary to initiate CIRP against the principal borrower before starting one against the corporate guarantor.

The NCLAT determined that if CIRP has been started against one of the corporate debtors, it cannot be started against the other corporate debtor for the same debt after that. This ruling was made while addressing and responding to the second question.

Thereafter, NCLAT ruled in SBI v. Athena Energy Ventures (P) Ltd. that the IBC permits concurrent initiation of CIRP against a principal borrower and its corporate guarantor.⁷

In order to make sense of the positions and settle any doubts regarding personal guarantor’s status under the IBC, the Union of India proposed a major amendment to the IBC in November 2019, which included personal guarantors and came into effect on and from 1-12-2019. Personal guarantors were not directly subject to the insolvency process prior to this notification.

The notification reads as under:

In the exercise of the powers conferred by sub-section (3) of Section 1 of the Insolvency and Bankruptcy Code, 2016 (31 of 2016), the Central Government hereby appoints 1-12-2019 as the date in which the following provisions of the said Code only insofar as they relate to personal guarantors to corporate debtors shall come into force:

(a) Clause (e) of Section 2;

(b) Section 78 (except with regard to fresh start process) and Section 79;

(c) Sections 94 to 187 (both inclusive);

(d) Clauses (g) to (i) of sub-section (2) of Section 239;

(e) Clauses (m) to (zc) of sub-section (2) of Section 239;

(f) Clauses (zn) to (zs) of sub-section (2) of Section 240; and

(g) Section 249.⁸

With the amendment, a creditor now has the option to initiate insolvency proceedings against the personal guarantor of a corporate debtor under Chapter III of the Insolvency and Bankruptcy Board of India. The procedure under the IBC for personal guarantors is very similar to the procedure for corporate insolvency resolution.

Furthermore, the IBC’s inclusion of a personal guarantor exposed them to the possibility of insolvency proceedings and the possible loss of personal assets. As a result, following the Notification dated 15-11-2019, a number of petitions challenging the notification’s validity and constitutionality were filed in various High Courts across the nation by promoters, directors, and other affected parties.

A bird’s eye view of the notification — Overview of the provisions

The creditors may start bankruptcy proceedings against personal guarantors under Section 95 IBC.⁹ They may choose to work with a resolution professional, work alone, or collaborate with others to accomplish this. The adjudicating authority will designate the chosen resolution professional to manage the personal guarantor’s insolvency resolution procedure if there are no disciplinary concerns with them. It should be mentioned that the personal guarantor is not given the chance to argue against the filing of an insolvency petition, the appointment of a resolution professional, or to make their case.

Although it is optional, Section 95(2) IBC permits the resolution professional to ask the debtor to produce proof of repayment for the amount that the creditor has asserted.¹⁰

In addition, Section 96 IBC places the personal guarantor under an interim moratorium upon the filing of an application to begin the resolution process.¹¹

Within ten days of their appointment, the resolution professional is required as per Section 99 IBC to review the application filed under Section 94¹² or Section 95 and submit a report to the adjudicating authority recommending the application to be approved or rejected.¹³

Following the report’s submission under Section 99, the adjudicating authority is required as per Section 100 IBC to render a decision within fourteen days. A moratorium is imposed as per Section 101 IBC if the application is accepted under Section 100 IBC.¹⁴

This moratorium restricts the personal guarantor’s ability to transfer, encumber, or dispose of their assets, legal rights, or beneficial interests. It also forbids the commencement or continuation of legal proceedings against the personal guarantor for any debt.

Challenging the constitutionality of 2019 notification: Lalit Kumar Jain to Anil Ambani case.

Following the notification by the Ministry of Corporate Affairs on 15-11-2019, regarding the insolvency of the corporate debtor’s personal guarantors, numerous petitions were filed before different High Courts of India by the Directors and the promoters contesting the said notification and its validity. In a significant ruling dated 21-52021, in Lalit Kumar Jain v. Union of India the Supreme Court addressed the constitutionality of the provisions of the IBC that permitted the initiation of insolvency process against personal guarantors, including the promoters, of a corporate debtor that is facing insolvency.¹⁵

The Supreme Court maintained the terms of the notification, ruling that the guarantor remains liable even if the corporate debtor or principal borrower is released from their obligation to the creditor through an involuntary process like insolvency. In essence, the Supreme Court opened the door for creditors to file for bankruptcy against the personal guarantors of a company debtor going through liquidation or insolvency.

In addition, the Supreme Court observed in Vidarbha Industries v. Axis Bank Ltd. that the provisions in IBC require the adjudicating authority to designate a resolution professional in cases involving personal guarantor without delving into the case’s merits or subjecting it to judicial scrutiny.¹⁶ Furthermore, Section 99(4) grants the resolution professional broad authority to ask the personal guarantor for any additional information or clarification regarding the application that may be necessary. Section 99(5) IBC requires the personal guarantor to furnish said information.

Additionally, Mr Anil Ambani has contested the legality of the bankruptcy and personal guarantee clauses enacted by the legislature. He has also reportedly questioned whether the IBC contains a provision allowing the National Company Law Tribunal (NCLT) to make such an order. The Delhi High Court responded by making it clear that the proceedings would go on regarding the corporate debtor (companies) and that the personal guarantor’s liability might be investigated during that process.

During the pendency of the Supreme Court appeal, the 2019 Amendment introduced provisions of the IBC pertaining to personal guarantors’ insolvency resolution (Sections 95-100), which were deemed constitutional by the three-Judge Bench consisting of Dr D.Y. Chandrachud, C.J. and J.B. Pardiwala and Manoj Misra, JJ.¹⁷

The petitioners contended that the personal guarantor was not given the chance to argue his position, contest the start of the insolvency resolution procedure, or challenge the designation of the resolution professional in accordance with the IBC.

The IBC statute “does not suffer from any manifest arbitrariness to violate Article 14¹⁸ of the Constitution”, the Court ruled.

Because the personal guarantors were not given the chance to be heard before the insolvency petition filed by creditors was admitted against them and the moratorium was automatically applied against them as soon as the insolvency petition was filed, the Bench stated that these provisions could not be deemed unconstitutional.

The ruling is a setback for the promoters who guaranteed the debt, even though it provides lenders with much-needed relief because it enables lenders to recoup/protect the portion of the debt that was not recovered during the CIRP of the principal debtor through the personal guarantor’s bankruptcy.

Good for lenders, bad for guarantors: How will the Supreme Court judgment fare?

The Supreme Court has affirmed the notification’s constitutional validity, as previously mentioned, and opened the door for banks and other financial institutions to file for the bankruptcy of personal guarantors of corporate debtors facing insolvency or liquidation proceedings before the NCLT.

The Supreme Court’s current ruling is extremely advantageous for banks and other financial institutions that use public funds in their operations because it will give them another tool to effectively collect their (bad) debts. With effect from the Notification dated 15-11- 2019, any foreign assets held by a corporate debtor’s personal guarantor may also be attached for the purposes of the debtor’s insolvency or bankruptcy. The NCLT has the authority to attach the foreign assets of the corporate debtor under insolvency.

For this reason, banks and other financial institutions will find it to be a useful tool in the fight against bad debts.

The question that must be asked in this situation is how cautious would banks and financial institutions be when handling small borrowers’ minor mistakes or defaults who have limited resources, particularly when it comes to charging compound interest rates. What options for settlement (one-time settlement plans, etc.) are available to banks for the minor defaulters they encounter in the regular course of business?

Furthermore, it is customary for the promoters or directors of a corporate debtor to offer a personal guarantee in transactions involving debt financing. When the entire stakes of the promoter/directors are involved in providing such guarantees, it will be important to note how the interests of such personal guarantors are protected in light of the current legal position.

Furthermore, there will undoubtedly be business repercussions if judicial interpretation favours personal guarantors at the expense of others. Guarantors are more likely to take a cautious approach when providing personal guarantees because of the limited benefit the IBC offers them and the possibility of facing alternative proceedings under the SARFAESI Act.¹⁹ This can be problematic. India’s businesses follow a promoter-led business model, and because of the Code’s precariousness, promoters’ promises may not come to pass. The corporate debtor may not have the funds to reimburse the guarantor once a liquidation or resolution begins, rendering the remedy provided by Section 140 of the Contract Act, 1872²⁰ futile. For guarantors, the risk quotient is significantly increased now that their guarantee will be actually and effectively invoked in case of default by a corporate debtor.

However, there are benefits to this position that are considered from a policy standpoint. Guarantors suffer, but creditors benefit greatly from the process of recovery. They have the authority to start legal action against the guarantor on their own, and more significantly, once the guarantor pays one creditor in full or in part, they are not allowed to use their right to subrogation to compete with the other creditors during the liquidation process. To some extent, this creditor-friendly stance is essential for India’s credit market to realise its full potential. Under the Code, corporate insolvency resolution has resulted in creditors being forced to accept large haircuts, frequently amounting to 90% or more.

It seems questionable how the IBC will be able to guarantee that creditors’ claims are resolved while the business continues to operate. Given this, the availability of a mechanism for recovering funds against the guarantor encourages credit flow — something that India desperately needs. Inequality will worsen if a nation’s credit system is still undeveloped and hazardous, which will limit credit availability only to the wealthy and well connected.

Even though creditors stand to gain from the recovery, credit can be more difficult to obtain without support guarantees, and this very circumstance may arise if guarantors are suppressed with stagnant provisions of law.

These provisions would only prevent micro and small corporate entities, as well as their promoter directors, from easily growing their businesses if they are not used carefully.

Given the current state of the legal system, this may also have an effect on a company’s and its promoter directors’ willingness to take risks and conduct business altogether.

Conclusion

The Supreme Court’s recent judgment²¹ on the inclusion of personal guarantors under the IBC marks a significant milestone in the legal landscape of India. The Court’s decision, upholding the constitutionality of key provisions of the IBC related to personal guarantors, has far-reaching implications for lenders, borrowers, and guarantors alike.

The journey began with the 2019 Amendment to the IBC, expanding its scope to encompass personal guarantors. The move was aimed at streamlining the insolvency resolution process and ensuring that guarantors are not exempt from liability when the corporate debtor defaults. The Supreme Court’s decision in Lalit Kumar Jain v. Union of India²² and Surendra B. Jiwrajka v. Omkara Assets Reconstruction (P)Ltd.²³ validated this amendment, emphasising that the release of the principal borrower through insolvency does not absolve the guarantor of their responsibility.

The judgment provides a robust legal framework for creditors, particularly banks and financial institutions, to recover (bad) debts effectively. This, however, raises concerns about the potential dominance of lenders and the need for a balanced approach, especially when dealing with minor lapses or defaults by smaller borrowers with limited resources.

While the decision benefits creditors, it poses challenges for personal guarantors, including promoters and directors, whose assets may now be at risk in insolvency proceedings. The ruling’s impact on settlement possibilities and the protection of personal guarantors’ interests will be crucial considerations in the evolving legal landscape.

From a policy perspective, the decision aligns with the need to incentivise credit flow for economic growth. However, the potential risks and challenges for guarantors may lead to a more cautious approach to providing personal guarantees. Balancing the interests of creditors and guarantors is essential to maintaining a healthy credit market and fostering economic development.

In essence, while the Supreme Court’s judgment²⁴ strengthens the recovery mechanisms for creditors, it also underscores the need for a nuanced approach to avoid unintended consequences on small businesses and the overall risk-taking capacity in the business ecosystem. As the legal system adapts to these changes, stakeholders must navigate the evolving landscape with prudence and foresight.