Status of Personal Guarantors under Indian Insolvency Laws

Introduction

In its decision in Lalit Kumar Jain v. Union of India², the Supreme Court allowed creditors like banks and other financial service providers to proceed against personal guarantors including promoters, MDs, and Chairmen of the corporate debtor for recovery of corporate loans under the Insolvency and Bankruptcy Code, 2016³ (IBC). The common objection of the petitioners who had furnished personal guarantees was against the validity of the Central Government Notification dated 15-11-2019 (notification) which brought into force Part III of the IBC relating to insolvency and bankruptcy of individuals and partnership firms insofar as it is applicable to personal guarantors and corporate debtors. This piece seeks to examine the judgment in light of its consistency with Indian contract law and also analyse its impact on the sector.

Case outline

Post the release of the notification, several personal guarantees were invoked causing complications in insolvency proceedings at different stages since adjudication against both corporate debtor and personal guarantor were now clubbed under National Company Law Tribunal’s (NCLT) charge. The petitioners contended that the exercise of power by the Central Government conferred to it under Section 1(3)⁴ IBC was vitiated by excessive delegation, as it does not have the authority to impose conditions on the enforcement of the IBC. Thus, enforcing provisions of Part III only in relation to personal guarantors of the corporate debtors was a condition imposed by the Central Government which was ultra vires of its powers. Since it is not a compulsion under IBC for it to be applied to all individuals at the same time, the Supreme Court upheld the notification and held the exercise of power as intra vires. Another substantive question of law to be ascertained by the Supreme Court was whether the personal guarantor is also discharged of its liability on sanction of a resolution plan like the corporate debtor. The Court’s examination of the same is analysed in the following section.

Consistency with the contract law regime

A. Co-extensive liability

The petitioners urged that the application of IBC to only personal guarantors would override the protection of guarantors in contract of guarantee under the Contract Act, 1872⁵ . Reliance was placed on the co-extensive principle under Section 128⁶ of the Contract Act, 1872, whereby, the liability of the surety is co-extensive with that of the principal debtor, and if the latter’s liability is discharged, so would the former’s. Thus, since the corporate debtor is discharged of any liability once a resolution plan is accepted, the personal guarantor’s liabilities must also be extinguished. Hence, by allowing creditors to separately proceed against the personal guarantors before the NCLT, the notification deprived them of their substantive statutory rights.

Rejecting this contention, the Supreme Court clarified that the sanction of a resolution plan and its finality under Section 31⁷ IBC does not per se discharge the guarantor’s liability. Relying on Maharashtra SEB v. Official Liquidator⁸, the Court held that within the meaning of Section 128 of the Contract Act, in a case of an unequivocal guarantee, the liability of the guarantor continues as there is no discharge under Section 134⁹ of the Contract Act. It was observed that the principal debtor is discharged by an involuntary process of operation of law and not by an act or omission of the creditor and thus the creditor can proceed against the guarantor. Therefore, the discharge of liability of the corporate debtor due to an operation of law in liquidation proceedings does not ipso facto absolve the personal guarantor from its liability.

Reliance was also placed upon SBI v. V. Ramakrishnan¹⁰ wherein the Supreme Court held that a discharge of liability could not be sought by the guarantor upon approval of a resolution plan which could contain terms allowing continuation of debt of the guarantors. Moreover, since the liability of the personal guarantor arises from an independent contract, the nature and extent of the liability would depend on the terms under the contract. Therefore, conclusively, the creditors have the option to simultaneously proceed against the corporate debtor and its personal guarantor or they can choose to proceed in any order.

B. Principle of double dip

The continuation of a creditor’s claim against the guarantor does raise a legitimate concern over double recovery. The Solicitor General in Lalit Kumar case¹¹ argued against this by relying on the principle of double dip, whereby the creditor can recover the same debt from two entities — principal debtor and guarantor or co-debtors or co-guarantors. Thus, until the creditor is paid the full amount, it can assert a claim for recovery against both or either of the entities or in case a portion is already paid by one, the other would be liable for the remaining amount as the liabilities of both are joint and several. Safeguards against double recovery are embedded in the contract law as also reiterated in the report of the Insolvency Law Committee that availability of simultaneous remedies against principal debtor and guarantor does not allow the creditor to recover more than the total debt due.¹² Other safeguards can be found in IBC provisions itself. For example, Section 14¹³, under which a moratorium prohibiting institution of suits or continuation of pending suits/proceedings against the corporate debtor can be declared by the adjudicating authority.

Juxtaposing the principle of double dip with the principle of double proof, the Solicitor General in Lalit Kumar case¹⁴ contended that the latter is concerned with the claim of recovery of the same debt against the same estate twice, thereby leading to double payment out of one estate. On the other hand, the former involves claim of recovery of same debt against two separate estates, which is permissible under the insolvency laws. Accepting the arguments of the Solicitor General, the Supreme Court relied on Kaupthing Singer & Friedlander Ltd., (No. 2), In re¹⁵, wherein the UK Supreme Court had held that the principle of double proof does not prevent creditors to benefit from the principle of double dip and creditors can claim the same debt against two separate estates. The UK Supreme Court had further clarified that the creditors can proceed against either or both principal borrower and guarantor. However, if both are insolvent, then the creditor can proceed against each for the full amount but cannot recover more than the full amount in all. Therefore, the Supreme Court recognised the double dip principle and allowed the recovery of only the stipulated debt amount irrespective of who the creditor decides to proceed against and in which order.

In an earlier decision of Vishnu Kumar Agarwal v. Piramal Enterprises Ltd.¹⁶, the Nclat held that an application once admitted against one of the corporate debtors including principal debtor or corporate guarantor(s), the second application by the same creditor for the same set of claims and default cannot be admitted against the other corporate debtor. It was also held that a claim cannot be filed by the same creditor in two separate corporate insolvency resolution processes (CIRP) of principal borrower and corporate guarantor, for the same set of debt. However, advancing Rakhecha argument, this is a kind of double dip which is permissible in law as by following the rationale in Kaupthing Singer case¹⁷, if both the principal borrower and the guarantor are insolvent, then the creditor can proceed against each for the full amount but cannot recover more than the full amount.¹⁸ Pursuant to the evident violation of the principle of co-extensive liability of both the principal borrower and the guarantor under Section 128 of the Contract Act, an appeal against the decision is still pending before the Supreme Court. It infringes upon the statutory right of the creditors by restricting them to proceed against any corporate debtor.

The Supreme Court in Lalit Kumar case¹⁹ provided much needed clarity for personal guarantors, especially since Piramal judgment²⁰ deals with corporate guarantors and not personal guarantors. The Supreme Court in Lalit Kumar case²¹ also held that the exception to moratorium envisaged under Section 14 extends to only corporate guarantors and not personal guarantors, thereby allowing a possibility of moratorium protection to personal guarantors unlike corporate guarantors. There is still an impending need for IBC to address such gaps in the legislation, especially in case of differential treatment of personal guarantors and corporate guarantors.

C. Right of subrogation

This statutory right under Section 140²² of the Contract Act puts the guarantor in the shoes of the creditor, allowing it to recover the amount paid on behalf of the principal debtor after the discharge of liabilities. A substantive question is whether a resolution plan allowing creditors to recover their dues from guarantors can, at the same time take away guarantor’s statutory right of subrogation. The IBC does not consider this right as an absolute right as it renders the process of insolvency pointless by further hampering the assets of the corporate debtor.

The petitioners in Lalit Kumar case²³ argued that the creditors’ rights enjoyed by the guarantor would also include the right to file a resolution plan against the corporate debtor after the resolution process, which in the petitioners’ contention, the promoters (who are personal guarantors in most cases) are barred from filing under Section 29-A²⁴ IBC. Thus, the petitioners criticised the impugned notification for the inability of personal guarantor to recover amounts from the corporate debtor.

The Court only briefly addressed this issue without delving into the fundamentals. Reliance was again placed on Kaupthing Singer & Friedlander Ltd. case²⁵, wherein the UK Supreme Court had reiterated that the principal debtor has a primary obligation towards the creditor and only a secondary obligation to indemnify the guarantor if and so far, as it discharges the principal debtor’s liability. Similarly, the guarantor has an obligation to the creditor to pay on behalf of the principal debtor but has only a secondary right to recovery from the principal debtor. However, the Supreme Court in Lalit Kumar case²⁶ left the argument at a vague note quoting UK Supreme Court’s observation in Kaupthing case²⁷ that, if the principal debtor is already insolvent then the guarantor may not enforce its secondary right in competition with the creditor.

Thus, it can be modestly inferred that the Court’s assessment is biased towards the fulfilment of the sole purpose of debt recovery. In Essar Steel (India) Ltd. Committee of Creditors v. Satish Kumar Gupta²⁸, the approval of Arcelor Mittal’s resolution plan providing deemed extinguishment of all claims of guarantors based on subrogation under the guarantee clearly indicated the prevalence of resolution plans over contractual rights of the personal guarantors. Such a right to denial vested with the corporate debtor is discriminatory as it advocates silencing of one set of guarantor’s rights to advance the rights of the creditors. Thus, effective safeguards need to be employed to prevent overriding of contractual rights.

Impact on the sector and concluding remarks

The judgment is beneficial to the creditors as it opens doors for them to access the asset pool of personal guarantors for debt recovery. However, it will also add to the already high bargaining power of the creditors against the corporate debtor leading to a concentration of powers with the creditors as now they have another route to recover loans besides the existing ones under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002²⁹ and debt recovery proceedings among other civil remedies. This might lead to a rise in quantity of litigation between the three stakeholders, creditors, corporate debtors, and their personal guarantors. The judgment may be worrisome for the promoters who act as personal guarantors for companies burdened with debt as they are not off the hook even after the acceptance of the resolution plan. In Ramanujam’s view, this violates the principle of limited liability and disincentivises entrepreneurial risk-taking which is equally important as comforting lenders for keeping the sector afloat.³⁰ Thus, it is agreed that the promoters do take an additional risk by offering personal guarantee, however, for further nourishment of the sector, the focus must be on diligence on borrowing over giving additional comfort support to the creditors.

The unification of proceedings under NCLT will not only allow the adjudicating authority and committee of creditors to consider the complete picture while evaluating the nature of assets and framing of an optimal resolution plan, respectively, but also help in avoiding unnecessary delays in the recovery process. During the hearings, Attorney General K.K. Venugopal contended in support of the notification that roping in guarantors would incentivise them to pay off the debt faster in view of obtaining a quick discharge. However, the decision of non-discharge of personal guarantors even after acceptance of resolution plan would evidently disincentivise them to respond quickly, thereby leading to delays.

Overall, there is no doubt that the judgment is more inclined towards the debt recovery aspect of insolvency proceedings as opposed to encouragement of the prime objective of IBC i.e. rescue of corporate debtors in distress. Without concretising the boundaries of right to subrogation after the recovery of debt by invocation of the personal guarantee puts the already debt-laden corporate debtor in a more uncertain position vis-à-vis repayment to the personal guarantor. With the possibility of extinguishing this right of the guarantors in the aftermath of Essar decision³¹, the corporate debtors would increasingly rely on the assets of the personal guarantor which may result in an increased risk appetite for taking loans, owing to the added cushioning. On the other hand, some also contend that the inclusion of the personal guarantor’s assets to mitigate the corporate debtor’s liabilities might lower the total debt servicing of the corporate debtor.³²

Post Supreme Court’s favourable decision, the creditors have invoked personal guarantees worth of Rs 34,000 crores in view of Rs 37,861 crores as the total debt default by companies.³³ Thus, evidently, the majority of the burden is falling on the personal guarantors as lenders try to recover the total debt. Although this will improve the financial health of the banking sector, but the interests of the personal guarantors need to be the top priority in order to keep it afloat in the future.