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IBC: AN UNFAIR CODE FOR PERSONAL GUARANTORS?

INTRODUCTION

The most conventional method used by banks and financial institutions while granting loans to corporations involve obtaining a guarantee from either the Director/Promoter/ Holding Company of the Corporation. Such a transaction leads to the creation of what is known as a Contract of Guarantee between the Bank, the Company taking the loan, and the Director. A Contract of Guarantee is defined as “a contract to perform the promise, or discharge the liability, of a third person in case of his default[1]. The Code defines a personal guarantor as “an individual who is the surety in a contract of guarantee to a corporate debtor[2]. In other words, a personal guarantor is a natural person who guarantees a loan taken by the corporate debtor.

PART III OF THE CODE: WHY IT BECAME OPERATIONAL?

Once a corporate debtor announces that it cannot discharge the debt, then banks/financial institutions will line up to take action against the personal guarantor. The answer to this can be found under the Indian Contract Act of 1872, which says: “The liability of the surety is co-extensive with that of the principal debtor unless it is otherwise provided by the contract[3].

In 2016, the Insolvency & Bankruptcy Code was passed. It is also pertinent to note that the Central Government has the power under the proviso to Section 1(3) to bring different provisions of the IBC into force on different dates, through a notification in the Official Gazette. This means that, at the time of its enactment, only Part I and Part II of the Code were operational. To put it differently, the part which deals with individual insolvency was never operational. This meant that, in the event of default, creditors had the option to initiate a CIRP only against the corporate debtor. Several personal guarantors took advantage of the loophole in the proviso was highly misused by the personal guarantors. Keeping this situation in mind, the Union Government notified the operation of Part III of the Code with effect from 1st December 2019.

THE POSITION OF GUARANTORS UNDER THE CONTRACT ACT VS UNDER THE IBC: IS THE CODE A DEATH BLOW TO GUARANTORS?

Various legal forums have extensively discussed the standing of personal guarantors under the IBC since Part III was implemented in 2019. It is primarily due to the dichotomy between the treatment of guarantors under the IBC and the Indian Contract Act, of 1872. The apparent disparity has led to a conflict between both of these legislations[4].

The conflict as such can be seen from two viewpoints:

  • Liability
  • Rights

FROM THE VIEWPOINT OF LIABILITY

As seen earlier, the Contract Act recognizes that the liability of both the corporate debtor and the guarantor is co-extensive[5]. That being the case, there arises a question as to whether a creditor can initiate a CIRP simultaneously against the corporate debtor as well as the personal guarantor. The same has been answered by the NCLT and the NCLAT in the judgments that are discussed below:

In the case of State Bank of India v Athena Energy Ventures Pvt Ltd[6], the NCLAT had ruled that an application against the borrower and the guarantor can continue simultaneously and there is no bar on such proceedings[7].

In SBI, Stressed Asset Management Branch v Mahendra Kumar Jajodia[8], SBI had filed an application to initiate a CIRP under Section 95 (1) against the guarantor. The same was rejected by the NCLT citing that the application was “premature”.  On appeal to the NCLAT, it was held that: “The Adjudicating Authority erred in holding that since no CIRP or Liquidation Proceeding of the Corporate Debtor are pending the application under Section 95(1) filed by the Appellant is not maintainable. Application filed by the Appellant was fully maintainable and could not have been rejected only on the ground that no CIRP or Liquidation Proceeding of the Corporate Debtor are pending before the NCLT[9].

From the aforementioned cases, it could be understood that there is no bar in instituting a CIRP against both the corporate debtor and guarantor simultaneously.

FROM THE VIEWPOINT OF RIGHTS

It is pertinent to understand that a contract of guarantee, under normal circumstances, gives rise to the right of subrogation. The right of subrogation[10], states that once the guarantor has paid off the debt of the principal debtor, he steps into the shoes of the creditor and is possessed of all the rights that a creditor has against the principal debtor[11]. However, to further the object of the IBC, which is to revive and rehabilitate the corporate debtor, the right of subrogation is sacrificed[12]. This is another reason why some legal scholars feel that the IBC is unfair as far as the interests of personal guarantors are concerned[13].

In one case, It was held that if the guarantor is allowed to recover the debt paid to the creditors post-CIRP from the corporate debtor, it would mean that the resolution applicant, who has now stepped into the shoes of the corporate debtor, would end up paying the original amount of debt that was owed, thereby defeating the object of the IBC[14].

After going through all of these provisions as well as the concerned judgments, we might feel that the Code is indeed unfair to guarantors. But it is to be understood that the very mechanism that operates upon a contract of guarantee is to protect the interests of a creditor, not that of the debtor. Bramwell L.J. in the case of Rainbow v Juggins[15] had opined that “Where a man enters into a contract of suretyship, he, it is true, bargains that he shall not be prejudiced by any improper dealing with securities to the benefit of which he as surety is entitled; but he makes that bargain concerning the law of the land, and if the law of the land says that under such and such circumstances certain things must take place to enable the creditor to do the best he can for his protection, then the contract of suretyship must be taken to be made subject to the liability of those things taking place.”

Keeping all of the aforementioned points in mind, it can be rightly said that the IBC is not unfair legislation when it comes to personal guarantors.

CONCLUSION

The IBC, 2016 provides for a robust insolvency and bankruptcy related framework in India. However, concerns have been raised by the legal fraternity regarding its treatment of personal guarantors. The current blog has tried to find out whether these concerns are true or not. A comprehensive definition for personal guarantors can be found in the IIRP Rules, 2019 which reads as: “a debtor who is a personal guarantor to a corporate debtor and in respect of whom guarantee has been invoked by the creditor and remains unpaid in full or part[16]. A bare reading of this definition points to the fact that as far as IBC is concerned, personal guarantors are also debtors. Such an approach ensures equitable treatment of all the stakeholders involved in the insolvency resolution process.  

The Code also provides for a negotiation-cum-settlement mechanism that allows a guarantor to actively participate in constructing a resolution plan, which takes into account both his financial capacity as well as the interests of the Committee of Creditors. To conclude, the IBC strives to offer a fair and balanced framework for personal guarantors. The current regime ensures that creditors are in a safer place when it comes to realizing their dues.

Author(s) Name: Radhika R Nair (School of Legal Studies, CUSAT, Kochi, Kerala)

Reference(s):

[1] Indian Contract Act 1872, s 126

[2] Adeeb Shah, ‘Personal Guarantor’s Footing Under Insolvency Law: An Upcoming Era of Change’ (2018) 4(5) JLSR <https://thelawbrigade.com/wp-content/uploads/2019/05/Adeeb-Shah.pdf> accessed 05 June 2023

[3] Indian Contract Act 1872, s 128

[4] Rishika Sharma and Samarth Kapoor, ‘Position of Guarantors under IBC: A Quandary Untouched’ (IBC Laws, 6 May 2022) <https://ibclaw.in/position-of-guarantors-under-ibc-a-quandary-untouched-by-rishika-sharma-and-samarth-kapoor/> accessed 5 June 2023

[5] Sonal Kumar Singh et al., ‘The Precarious Plight of a Guarantor under the Insolvency and Bankruptcy Code, 2016’ (Mondaq, 28 January 2021) <https://www.mondaq.com/india/insolvencybankruptcy/1030860/the-precarious-plight-of-a-guarantor-under-the-insolvency-and-bankruptcy-code-2016> accessed 5 June 2023

[6] State Bank of India v Athena Energy Ventures Private Limited [2020] Company Appeal (AT) (Ins) No.633

[7] Rishika and Samarth (n 4)

[8] SBI, Stressed Asset Management Branch v Mahendra Kumar Jajodia (2022) Company App (AT) (Ins) No 60

[9] Rishika and Samarth (n 4)

[10] Indian Contract Act, 1872, s 140

[11] Madhu Gadodia and Shashank Trivedi, ‘Right of Subrogation to the Rescue of the Guarantor? Stepping in the Shoes of the Creditor’ (Bar and Bench, 29 August 2022) <https://www.barandbench.com/law-firms/view-point/right-of-subrogation-to-the-rescue-of-the-guarantor-stepping-in-the-shoes-of-the-creditor> accessed 05 June 2023

[12] Rishika and Samarth (n 4)

[13] Adv. Yash Gupta and Adv. Vishwajeet Singh, ‘Examining the Right of Subrogation under IBC: Current Status and Implications’ (IBC Laws, 2 March 2023) <https://ibclaw.in/examining-the-right-of-subrogation-under-ibc-current-status-and-implications-by-adv-yash-gupta-and-adv-vishawjeet-singh/> accessed 05 June 2023

[14] Sonal and Anshuman (n 5)

[15] Rainbow v Juggins [1880] 5 422 (QBD)

[16] Insolvency and Bankruptcy (Application to Adjudicating Authority for Insolvency Resolution Process for Personal Guarantors to Corporate Debtors) Rules 2019, r 3(e)