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This article is written by Sneha Solanki pursuing a Certificate Course in Insolvency and Bankruptcy Code from LawSikho.

Introduction

As, India implemented its robust legislation on 28th May 2016, to revive and maximize the assets of the corporate debtor. But as soon as the judgment of Lalit Kumar vs Union of India & Ors came in May 2021, a huge tussle started that if the code has become a recovery mechanism more than a way of bringing the corporate debtor back on its feet. With the present judgment, it is clear that personal guarantors’(hereinafter referred to as PGs) liability will continue even after the approval of the resolution plan, or even after the liquidation for a debt-laden company which was earlier used to get extinguished with the approval or resolution. The judgment has also made it difficult for PGs to claim back their money from the corporate debtors. This judgment came a month later the Supreme Court held that all dues payable to Centre, state, or tax authorities will freeze if they were not part of the approved resolution plan, which will prevent the personal guarantor fall prey to the sudden claims by other creditor making it more complex. 

Definition of the personal guarantor

A personal guarantor is an individual who is the surety in a contract of guarantee to a corporate debtor. Further, “guarantor” means a debtor who is a personal guarantor to a corporate debtor and in respect of whom the guarantee has been invoked by the creditor and remains unpaid in full or part.

The question of extinguishment of liabilities of the personal guarantor was looked upon Kundanlal Dabriwala v. Haryana Financial Corporation, in terms of contract act, held that the liability of the surety is co-extensive with that of the principal debtor, then if the latter’s liability is extinguished in whole or in part, then the liability of the surety is also reduced or extinguished. The latest judgment has clarified that approval of a resolution plan of a debtor company, does not discharge the liability of a personal guarantor, has now cleared out the way for 75 petitions that were filed by different personal guarantors including Anil Ambani, Venugopal Dhoot, Kapil Wadhawan, etc. 

On one hand, where it is a sigh of relief for the banks who earlier had to compromise with large haircuts, now can ensure a good recovery rate. Also, Promotes who will be more focused on settling the dues and refrain from getting the company into Corporate Insolvency Resolution Process (hereinafter referred to as CIRP) which earlier was not the case, and the situation somewhat favors the defaulting promoters to get away with the liability after approval of the resolution plan. In cases of larger dues, promoters were more inclined to get the company into CIRP, leaving the principal debtor at the disadvantage. After this judgment, it will require the guarantors to re-assess the terms of the guarantee concerning how much risk they can take, eventually making strong and transparent management who is aware of its duties and can perform them if the situation requires. 

Further, the present judgment has silently answered the concern of the guarantor, by citing the case of Vijay Kumar Jain vs. Standard Chartered Bank & Ors where it was held that the board of directors (Personal guarantors) eligible to attend the Committee of Creditors (hereinafter referred to as COC) meeting and also eligible to get an advance copy of the plan along with notice as such members of the erstwhile Board of Directors, who are often guarantors, are vitally interested in a resolution plan as such resolution plan then binds them. Such a plan may scale down the debt of the principal debtor, resulting in scaling down the debt of the guarantor as well, or it may not. 

An ambiguity of the judgment leading to litigations against the personal guarantor

On the other hand, it might open floodgates of cases against the personal guarantor. Also, there is no denying the fact that the creditors who earlier were not able to claim their money due to late submission of claims or any other default on their part will also try to initiate proceedings against the PGs making them a victim of an unintended consequence. Following the judgments, there is a need of streamlining the law for the personal guarantors, because of the following problems that can be seen soon.

  1. Right of Subrogation: Where the judgment at hand is unclear about the rights of the guarantor on stepping into the shoes of the creditor. Another judgment by the NCLAT in the case of Lalit Mishra and Ors vs. Sharon biomedicine held that the guarantor cannot exercise its right of subrogation under the Contract Act as proceedings under the IBC are not recovery proceedings. Further, the object of the proceedings under the IBC is to revive the company and focus on maximization of the value of its assets and not to ensure that credit is available to all stakeholders. Thus, no such recovery can be made by a guarantor. Also in most cases, the promoters being the guarantors for the company, makes it impossible for them to recover their money because of the restriction under 29A which provides for ineligibility of the people who can file their claims.
  2. Economic Freedom: It is well established that economic freedom and economic performance have a very high positive correlation. Markets need freedom broadly at three stages of a business – to start a business (free entry), to continue the business (free competition), and to discontinue the business (free exit).

Where the first two elements are very well secured by IBC, the third element which talks about taking an exit from the market can be difficult for genuine business failure. A firm may fail to deliver because of a variety of reasons. If the company is taken to CIRP and subsequently to liquidation, there are very many chances that personal guarantors have to sell off their assets and which can cause irreparable loss to them. This can result in a surge of fewer people giving guarantees fearing an unreasonable burden on the company as there is broad management who is running the company apart from the promoters then why such pressure on particular stakeholders?

3. Also, the law is silent on what to do, when proceedings for the same claim against the principal debtor is going on for months and now, suddenly there is a new proceeding that will start from the inception against the personal guarantor the same process under IBC has to go again which makes it a tedious task unless and until it is the same resolution professional handling the case.

4. Attacking the personal guarantor: Another matter of concern is that the creditors are allowed to approach the personal guarantors even before the creditor has not exhausted his remedy against the principal debtor, which means that PG will have to give away their assets for the company who might be able to fulfill the claims causing undue pressure on the guarantor. The same was established in the case of Bijay Kumar Agarwal Vs. State Bank of India and Anr. Stating that “Even without resorting to CIRP against the principal borrower it is always open to the Financial Creditor to commence CIRP u/s 7 of the Code against the Corporate Debtor / Guarantor”.

5. While the objective of the code is to “restructure the company”, the judgments are making it look like a “recovery mechanism for the creditors” making it a rat race for them, by which they can recover their claims either from PG or CD, without following a settled way, where they have to approach the principal debtor and if that does not fulfill their claim, then they approach the guarantors.

6. Drawing difference between legitimate succession planning and evasion: The latest judgment will bring legitimate structures into question and paint every movement of assets into trusts with a bad faith brush. In other words, it can take into scrutiny any asset that has been transferred by the promoter around the time period where the CIRP has commenced to mark as a favorable transaction and the reason for this is lack of clarity on what actions or steps taken by the promoter can or cannot amount to an unacceptable transaction as there is no bright-line test for the promoters to differentiate between a regular transaction or if that is an evasion to refrain them from getting their assets into CIRP. 

7. Keeping in mind the delicacy of the situation, it is important to strike a balance between the creditor and the debtors, where the IBC model is a creditor in control model, but providing excess power to them, might not prove fruitful in the long run, especially for the MSME groups which certainly start their business by pooling funds from their friends and family.

Solution

Equitable contribution is a common-law doctrine predating the enactment of the Bankruptcy Code, designed to remedy misconduct that causes injury to creditors (or shareholders) or confers an unfair advantage on a single creditor at the expense of others. The application of this can be very well seen in the case of J.R. Agro Industries private limited v. Swadisht oils Private Limited where NCLT Allahabad ordered a modification of a resolution plan that gave priority to the related party financial creditors over the operational creditors by applying the principle enshrined in UNCITRAL Legislative guide which specifies that when an organization owes debts to more than one creditor, the priority scheme established under the applicable law may provide for the subordination of certain types of claim: for example, the determination of the priority of related party claims. Further, the doctrine of equitable subordination also provides that a court can permit the subordination of a controlling shareholder’s claims upon debt to those of other bona fide creditors in bankruptcy if the controlling shareholder has behaved unfairly or wrongly towards the company and its outside creditors. In line with the aforementioned decision of the NCLT Allahabad and the doctrine of equitable subordination, this judgment acts equitably by differentiating the promoters from other creditors and shareholders.

Conclusion 

While it is extremely necessary to fill up the loopholes for the efficient working of this code, making it stringent for one class of shareholders, who have to fulfill the claims of lenders and have no way to get his funds back, seems unreasonable. Further, Ring-fencing the debtor from his other liabilities and securing the creditor at once can be an issue of concern for the new industries coming in. A process that is humane, fair, and offers debt relief can significantly reduce psychological distress among debtors, and encourage risk-taking and entrepreneurship. At last, what we see from the above-mentioned judgment is an endless liability on the personal guarantor, there must be a clear demarcation of their rights and liabilities, which can help the insolvent start afresh!

References 

  1. https://www.jonesday.com/en/insights/2008/10/absence-of-actual-harm-to-creditors-defeats-equitable-subordination-bid
  2. https://www.nipfp.org.in/media/medialibrary/2019/02/WP_251_2019.pdf 
  3. https://www.sngpartners.in/2021/05/26/sc-order-on-personal-guarantors-thorn-in-the-side-of-biz-families/ 
  4. https://www.ibbi.gov.in/uploads/resources/the%20Insolvency%20and%20Bankruptcy%20Code,%202016%20builds%20the%20third%20Pillar%20of%20Economic%20Freedom%20in%20IBBI%20Newsletter%20October-December%202016.pdf. 
  5. https://www.mca.gov.in/Ministry/pdf/TheInsolvencyandBankruptcyofIndia.pdf. 

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