India: Personal Guarantors Under The Insolvency And Bankruptcy Code, 2016 – The Road Ahead

Recently on 21 May 2021, Supreme Court in Lalit Kumar Jain v. Union of India, 2021 SCC OnLine SC 396 (Lalit Kumar), upheld the Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules, 2019 (2019 Rules) notified by the Indian Government on 15 November 2019 (effective from 1 December 2019).

The 2019 Rules inter alia notified Section 2(e) of the Insolvency and Bankruptcy Code, 2016 (Code) in relation to personal guarantors to corporate debtors, who were recognized as a distinct category of individuals vide the Insolvency and Bankruptcy Code (Amendment) Act, 2018 (2018 Amendment Act), effective from 23 November 2017. The 2018 Amendment Act inter alia created three distinct categories of persons: (i) personal guarantors to corporate debtors; (ii) partnership firms and proprietorship firms; and (iii) individuals, with a view to treat each category differently under the Code.

Vide the 2019 Rules, Part III of the Code was made separately applicable to personal guarantors to corporate debtors. Resultantly, a creditor could initiate corporate insolvency resolution process (CIRP) against personal guarantors to corporate debtors before the Debt Recovery Tribunal (DRT). Further, by virtue of the amended Section 60 of the Code (as amended vide the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, effective from 6 June 2018), if CIRP is initiated against a corporate debtor before the National Company Law Tribunal (NCLT), any proceedings for recovery initiated against personal guarantors to corporate debtors undergoing CIRP, in any Court or Tribunal, would stand transferred to the NCLT, and any proceedings sought to be initiated against personal guarantors to corporate debtors must be done so before the NCLT.

In the Lalit Kumar, the Petitioners challenged the 2019 Rules primarily on the grounds that: (i) the Central Government has exceeded the power conferred upon it under Section 1(3) of the Code by modifying provisions of the Code and making the same selectively applicable to a category of persons, which it was not authorized to do; (ii) initiating proceedings against the corporate debtor as well as the personal guarantor to a corporate debtor would amount to a "double recovery" which is impermissible under the Code; and (iii) in case a resolution plan extinguishes the existing debts of a corporate debtor, the liability of the personal guarantor to a corporate debtor, being coextensive by virtue of Section 128 of the Indian Contract Act, 1872 (Contract Act), must also stand extinguished.

The Supreme Court, however, rejected the contentions of the petitioner and upheld the 2019 Rules inter alia on the grounds that: (i) the Central Government envisaged a stage-by-stage induction of the Code keeping in mind the object and purpose of the Code, which is permissible in law; and (ii) where a debt is extinguished by operation of law, the liability of the personal guarantor subsists independent of the liability of the corporate debtor. The Supreme Court stated that the rules were aimed at strengthening the CIRP and that keeping in mind the intimate connection between personal guarantors and corporate debtors, allowing proceedings in separate forums in relation to the aforementioned parties could lead to uncertain outcomes and defeat the purpose of the Code.

Implications

Lalit Kumar is seen as a welcome move by creditors, as now they may recover their dues from both the corporate debtor and the personal guarantor thereof under one forum simultaneously. Further, Lalit Kumar reiterates the position in Committee of Creditors of Essar Steel v. Satish Kumar Gupta, 2019 SCC OnLine SC 1478, namely, upon completion of the CIRP of a corporate debtor, the creditors who would otherwise be taking a haircut, are entitled to separately proceed against the personal guarantor to the corporate debtor to recover the remainder of the amounts, assuming the resolution plan does not extinguish the guarantors' liability. However, this implication will disincentivize individual personal guarantors from extending a guarantee to corporate debtors.

Position of personal guarantors prior to the 2019 Rules

Before the 2019 Rules were notified, Part III of the Code was inapplicable to personal guarantors to corporate debtors. Creditors then had the option of proceeding inter alia through: (i) the civil courts under the Presidency Towns Insolvency Act, 1909 or the Provincial Insolvency Act, 1920; (ii) a civil suit enforcing their contractual remedies; and (iii) other specialized legislations inter alia including the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002.

However, after the 2019 Rules were notified, creditors are also entitled to approach the DRT under Part III of the Code as well as the NCLT under Part II of the Code for recovery of dues from personal guarantors. Additionally, the avenues of recovery that existed prior to the 2019 Rules, continue to subsist as Section 243 of the Code, which seeks to repeal the Presidency Towns Insolvency Act, 1909 & the Provincial Insolvency Act, 1920, has not yet been notified.

Simultaneous Proceedings

Section 128 of the Contract Act states that the liability of a guarantor shall be co-extensive to that of the principal debtor. In other words, the corporate debtor and the personal guarantor being jointly and severally liable to repay the debt of the creditor, the Contract Act does not prevent a creditor from proceeding against a guarantor prior to exhausting his remedies against the principal debtor.

This principle of contract law is interposed under the Code as well.  The Supreme Court in State Bank of India v. V. Ramakrishnan & Ors, (2018) 17 SCC 394, and the National Company Law Appellate Tribunal (NCLAT) in State Bank of India v. Athena Energy Ventures Private Limited, 2020 SCC OnLine NCLAT 774, have stated that creditors are entitled to initiate simultaneous proceedings before the NCLT as against the corporate debtor and before the relevant forum as against the personal guarantor.

Taking a contrary view, the NCLAT in Dr. Vishnu Kumar Agarwal v. Piramal Enterprises Ltd, 2019 SCC OnLine NCLAT 542, (Piramal) had held that once a claim filed by a creditor under Section 7 of the Code is admitted as against the corporate debtor or the personal guarantor as the case may be, no proceedings for the same set of claims may be initiated against the other.

While the Piramal judgment is under challenge before the Supreme Court, in light of the Lalit Kumar and Section 60 of the Code, it is clear that while simultaneous proceedings against both the personal guarantor and the corporate debtor are permitted, this can only take place before the NCLT and with the caveat that creditors cannot recover an amount greater than their total claim amount. The Report of The Insolvency Law Committee dated February 2020 also stresses on the importance of permitting simultaneous recovery while ensuring no creditor unjustly enriches themselves beyond the amount owed to them.

Personal guarantor's right of subrogation

The Contract Act in Section 140 states that "Where a guaranteed debt has become due, or default of the principal - debtor to perform a guaranteed duty has been taken place, the surety, upon payment or performance of all that is liable for, is invested with all the rights which the creditor had against the principal – debtor".

The aforesaid right of subrogation is an essential principle of the law of guarantee, as it makes the same commercially viable. However, as noted by the Supreme Court in the Lalit Kumar as well as by the NCLAT in Lalit Mishra & Ors.  v. Sharon Bio Medicine Ltd. & Ors., 2018 SCC OnLine NCLAT 669, the right of the personal guarantor, upon invocation of the guarantee by a creditor, to recover the same from the corporate debtor, ceases to exist in furtherance of the larger purpose of the Code to revive corporate entities.

This would effectively leave a personal guarantor remediless if the resolution plan (which is approved by the creditors) envisages extinguishment of the personal guarantor's right of subrogation. The NCLT has in the past approved of resolution plans extinguishing such rights in State Bank of India v. Calyx Chemicals & Pharmaceuticals Limited, 2018 SCC OnLine NCLT 28227 and IDBI Bank Ltd. v. EPC Constructions India Limited, 2019 SCC OnLine NCLT 583.

The Supreme Court has hence selectively applied the principle of guarantee, stating that the Code, under Section 238, is equipped with overriding powers vis-à-vis other statutes. The resultant situation is that while the liability of a personal guarantor under the Contract Act is retained, his corresponding right is restricted, which goes against established general principles of law and equity, and would amount to 'unjust enrichment' by the corporate debtor.

Personal guarantor's liability to be extinguishes upon the extinguishment of the principal debt

Sections 133, 134, 135 & 140 of the Contract Act envisages that the liability of a guarantor, being co-extensive with that of the debtor, would stand extinguished in case the debt of the debtor is also extinguished. However, the Supreme Court in the Lalit Kumar, has held that in case the debt of a corporate debtor is extinguished by 'operation of law' as opposed to a contractual arrangement, the liability of the guarantor is not extinguished.

Conclusion

This position taken by the Supreme Court, in order to benefit creditors, has left personal guarantors in a precarious position. The Supreme Court in Swiss Ribbons Private Limited v. Union of India, (2019) 4 SCC 17, stated that the object and purpose of the Code is to ensure revival of the corporate debtor and have warned against using the Code as a mere 'recovery tool'.

However, the present creditor-centric model, at the cost of general principles of contract and law, has led to just that. By allowing the creditors to pursue against the personal guarantor for recovery of their dues without providing the corresponding right to the personal guarantor, the Code has become a tool for recovery benefitting the creditors. Further, the creditors themselves, through the committee of creditors (CoC) are the ones approving the resolution plan under Section 30 of the Code, which would leave the guarantor with no recourse if his contractual rights are extinguished.

That being said, there are a few ways in which the present position could be altered to encourage personal guarantors from a commercial point of view while concurrently maintaining the object and purpose of the Code, being revival of the corporate debtor.

One such way is in cases where there CIRP is simultaneously initiated against the corporate debtor and the personal guarantor, the NCLT may first pass appropriate orders vis-à-vis the personal guarantor to the corporate debtor, so that he may then include his claim into the resolution plan, in his newfound capacity as a creditor exercising his right of subrogation. The Code also provides a safeguard, in case the personal guarantor is the promoter, under Section 21(2) of the Code, which prevents a related party financial creditor from participating in the CoC.

Alternatively, the NCLT could seek to distinguish between personal guarantors who are promoters of the corporate debtor (or related to the promoters of the firm in any manner) under CIRP and independent personal guarantors who have offered a guarantee form a commercial perspective. Creating such a distinction would prevent promoters who may have contributed to the insolvency of the corporate debtor from benefitting from the same while incentivizing independent guarantors to continue providing guarantees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.